Recently a reader wrote in explaining that she’s going through the refinancing process. Like many students, she incurred approximately $170K in student loan debt and has a starting salary of $140K. Those are pretty typical numbers based on my experience.
Despite the “normal” amount of debt, she quickly realized that there was nothing “normal” about paying more than $11,000 in interest each year. Worse, even a $140K salary can only do so much damage on students loans when you need almost a $1,000 each month just to clear the interest hurdle before you can start to reduce the principal balance.
In these situations, refinancing is a no brainer. I meet lawyers all the time who are switching into these low 3% variable rates. You’re all so lucky. When I graduated law school, there were no fancy loan refinancing companies. The best you could do was consolidate your federal loans. Many people mistakenly thought they’d get a better deal, but it often made the interest rate slightly worse. The only benefit of consolidation was that you had one loan to pay instead of eight.
Being able to cut your interest rates in half is a miracle and one that will save you thousands of dollars over the course of your loans (perhaps even $10s of thousands of dollars).
In a previously article, I wrote about whether you should select a variable or fixed rate when deciding to refinance. I won’t rehash the arguments here, but suffice to say that the variable rate wins three out of four times and is probably the way to go for you too.
Picking a repayment term
This particular reader wanted to discuss term length. Most of the student loan companies give you options. The typical term lengths offered are 5, 7, 10 and 15, although some companies offer smaller or larger term lengths. In each case, you pay a slightly higher interest rate if you take a longer repayment term.
On the other hand, a longer team means smaller monthly repayment amounts, which makes managing your cash flow a little easier. These smaller monthly repayments are attractive because even people who plan to aggressively pay off their loans can benefit if they have a few months where they might only make the minimum payment.
Student loan companies that offer longer terms and therefore lower monthly payments are attractive to risk-adverse lawyers (i.e. all of us). We’re trained to think of the many ways things can go wrong and naturally we want to reduce the risk, both for ourselves and our clients.
But I’ve found that lawyers aren’t always the best at evaluating risk. We’re trained to identify it and avoid it, but usually the clients decide whether to take the risk or not.
In deciding which term length to pick, it’d be helpful if we could conceptualize the risk.
There’s a risk that you lose your job and income. There’s a risk that you have some unexpected expenses in one month. There’s a risk that something bigger happens in your financial life that prevents you from making student loan payments. In these situations, you’ll be better off if your monthly payments are lower as it gives you more flexibility.
But it’s important to understand that this risk exists no matter what. It’s not like you can wave a magic wand to make it go away.
So the question is, who should take on that risk?
Either you can take it or you can give it to the student loan company.
If you take on the risk by agreeing to a higher monthly payment, the student loan company will reduce their interest rate. Higher monthly payments means you’ll pay off your loan faster, reducing the possibility of something like a death or disability that could lead to your inability to pay the loan. By reducing the risk for the bank, they charge a lower rate.
If you let the student loan company take on the risk by choosing a lower monthly payment, the student loan company will increase their interest rate. Lower monthly payments means it’ll take you longer to pay off your loan, increasing the possibility of something like a death or disability that could lead to your inability to pay the loan. By increasing the risk for the bank, they charge a higher rate.
Make sense? The risk is there. It’s all about who takes it on.
Once you think about it in these terms, the decision should crystalize for you.
You should take on as much risk as you’re comfortable with.
In my view, the risk discussed above is the best kind for you to take on because it’s almost all within your control.
Worried that you’ll lose your job and income? Focus at work and save up an extra cushion to make student loan payments for a few months should the worse happen.
Maybe you’re concerned that one month you’ll have some unexpected expenses and not be able to meet your minimum monthly payment? Save up an emergency fund and get better at budgeting your income.
In both cases, you’ve taken steps to reduce the risk (steps that the bank could never take) and consequently will be rewarded by paying a lower interest rate.
Now, this doesn’t mean that you tie yourself in knots taking on risk after risk. You can actually boil it down into numbers. If the difference between two terms is a 0.25% increase in interest, the student loan companies have priced the risk for you.
Let’s consider two examples. The reader owes $170K. Let’s say option 1 is a comfortable monthly repayment and option 2 is a uncomfortable repayment, but that both payments are “doable”. In this hypothetical, the difference between the two options is a 0.50% interest rate. Your risk calculation is simply $170,000 x 0.005 = $850/yr.
Now it’s up to you to decide. Would you rather pay $850 a year for the life of the loan to offload the risk and have the comfortable monthly payments? Or do you think it’s worth it to save the $850 each year in order to manage the risk yourself? The decision is yours.
Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He is always negotiating better student loan refinancing bonuses for readers of the site.
