By Joseph Reinke, CFA
When I speak to recent graduates about their student loan grace period, I often hear two very different comments. The first, "I want to start paying my student loans immediately so I can save money." The second, "I do not need to worry about my student loans because I'm in my grace period." Who's right?
The first is somewhat correct because it depends on your goals. The second is always incorrect because you need to understand and plan a student loan repayment strategy as early as possible...and no, ignoring your student loans is not a strategy. It is a costly mistake. This article discusses strategies for you to implement during your student loan grace period.
- What Is The Student Loan Grace Period
- Goal #1 During Your Student Loan Grace Period:Starting A Reserve Account
- Sticking with an Easy Strategy: Pay Down & Save
- Going with the Advanced Strategy: Invest
For those of you who prefer to watch a video, the videos below detail these strategies.
What Is The Student Loan Grace Period
First things first. The student loan grace period occurs immediately after you graduate. You are given six months whereby you are not required to make payments on your student loans. Each Federal Student loan has one student loan grace period. Therefore, if you already used it you do not get another one.
For example, if you received an undergraduate degree and then worked. After a year or two, you decided to go to grad school, on your undergraduate loans you do not get another student loan grace period. However, you can call your loan servicer and request that they put you on administrative forbearance.
Starting A Reserve Account
Many recent graduates want to immediately begin paying off student loans during their student loan grace period. The reason is they want to save the most money. This is a good mindset to have but there are other actions to take first.
The first action you should take is to establish a reserve account. A reserve account is another name for a rainy day fund or an emergency fund. Having a reserve account allows you to weather financial shocks. These include changing jobs, being laid-off, having to move, etc... The question to answer is how much money do you need in reserve?
There are a number of factors that determine how much to have in reserve. The most important are your risk tolerance and what profession you are in. For example, if you are in an in-demand profession, you should be able to find employment fairly easily. Therefore, you could potentially have a lower amount in your emergency fund.
Risk tolerance simply means how many months of "buffer" you need to feel comfortable should your situation change unexpectedly. This buffer is simply how long you would want to "survive" having zero income and being able to meet your monthly expenses.
To calculate your reserve account, you must first estimate your monthly expenses that are necessities. Items such as food, utilities, rent, etc... Then determine how many months you would like saved up and multiply by your monthly expenses. For example, if your monthly expenses are $2,000 and you would like a 3 month reserve, then you would need $6,000 ($2,000 x 3). Once you have that amount saved then you can decide on pursuing the Easy Strategy or the more Advanced Strategy discussed below.
Easy Strategy: Pay Down & Save
If you already have a reserve account then you need to either start making payments or saving. If you have chosen the Pay Down strategy and not the IDR Tax Savings strategy then you'll want to start making payments during your student loan grace period as soon as you have your emergency fund saved.
This will save you money and get you out of debt sooner. To illustrate how much you would save I will illustrate with an example. This example also illustrates why deferring "just because you can" is a (very) costly strategy. We will make the following assumptions:
- The loan is 10 years
- Student loan grace period of 6 months
- $100,000 loan balance
- 100% of the loan is unsubsidized
- The loan has a 6.85% interest rate
If you deferred your loan during the student loan grace period, it would accrue $3,425 in interest. After the six month student loan grace period ends the interest is capitalized. This means that the $3,425 is added to your loan balance and your new principal balance is $103,425. Over your ten year repayment period, you would pay a cumulative amount of $143,144.
To compare, let's assume you were actually working during your student loan grace period, you had a reserve account, and you could afford to make payments. Therefore, you started repaying your student loans immediately upon graduating. Your cumulative payment amount over the life of the loan would be $138,404. In other words, not deferring interest during your student loan grace period would save you $4,739.
To those that say they don't need to think about their student loans during the student loan grace period, you just cost yourself a decent amount of money. To make things worse...if you invested that $4,739 in a retirement account for thirty years at a 5% annual return you would have $21,172.
Advanced Strategy: Invest
For those of you that want a more "advanced" strategy then the following analysis must be performed. In this scenario, you must consider either 1) paying down your debt or 2) keep the money and invest it instead.
Using the above example, if you do not make payments during the student loan grace period, then it costs you $3,425 during those six months in deferred interest. You then have to ask yourself, "If I save that $3,425 during those six months and invest it for ten years, what annual rate of return would I need to achieve over that period to end up "ahead"?" This annual rate of return is called a break-even rate of return.
To calculate this break-even rate of return you need to consider the following:
- Per our example, not making payments during the student loan grace period would generate $3,425 in deferred interest.
- Per our example, deferring during the grace period would end up costing you $4,739 over the ten year repayment period.
The question to then answer is, "If I invested the $3,425 for ten years, what annual rate of return would I have to achieve to grow this amount to $4,739?" The answer is 3.25%.
That means if you think you could earn over 3.25% during the ten year period, it would make sense for you to defer during your student loan grace period and invest.
There is one caveat to this number however: the 3.25% would be a risk-free rate of return. If you think you can earn 6%-8% by investing in the stock market, you have to remember, there is risk in those returns. This doesn't change the analysis but is another factor to be aware of.