Student Loans Explained | How Do They Work?

 
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I have recently received a lot of questions in regards to student loans and what are the best strategies in order to pay them in the most efficient way possible. Well for those who have questions…. here we go!

Subsidized vs. Unsubsidized

The key difference to realize here is SUBsidized loans are loans that you do not have to start paying interest on until you graduate college. In order to qualify, you must be a ½ time student and be in a financial situation where a loan will help you with the burdens of college expenses.

UNsubsidized, is just the opposite. You do not have to qualify, the interest of the loan starts adding up immediately, and unlike a subsidized loan, there is no 6-month grace period for you start paying after graduating.

Get it?

Student Loan Interest Deduction

If you have student loans, the current amount of interest that you can deduct is $2,500. The easiest way to figure out how much of your loan is tax deductible is to do the following:

  • Take $2,500

  • Divide it by your average interest rate

  • This gives you the amount of your loan that is going to provide you the highest tax deduction benefit

Example:

You have $50,000 in student loans, with an average interest rate of 7%.

$2,500 divided by 7% (.07) is approximately $35,714.

What this means is that the difference of $14,286 is not providing you any sort of tax benefit if you qualify for the tax deduction.

Which loans do I pay off first?

The amount of your loan that does not provide you any tax benefit, considering the highest interest rate, should be the loans you prioritize first.

From there, as you make your monthly payments, you will see that your total loan balance decreasing, you are maximizing your tax deduction, and pinpointing the loans that are working against you.

Loan Repayment Financing

The goal here would be lower the amount of interest you pay on your student loans. However, beware if you speak to someone who says they can lower your payment, your interest rate, but increase your term.

The reason why is that despite you saving “money” on your payment each month, in reality, you are just paying more interest than if you just kept your normal payments.

Always consult with someone who you know who is knowledgeable in the subject before making a big decision such as refinancing your student loans.

Income Based Refinancing

Be very careful when it comes to refinancing your student loans that are “income” based. The reason why is if you expect to be receiving raises or promotions in the future, this can negatively affect you in the long-run.

A friend of mine refinanced based off of their income, which was around $35,000. After working at their company for a few years, they received a promotion, a raise, and that ended up hurting them because of income based refinancing.

Now, they are stuck in a payment that is actually larger than it was originally, which is not a benefit but added baggage onto their financial picture.

If you are someone who’s income is not going to be fluctuating over the first 10 years of their career, then maybe income based refinancing makes sense. Just be cognizant that sometimes, it pays just to keep things the way they are.

 

Loan Repayment vs. Investing

This is a tricky question and it all depends on two details:

  • What is the interest rate you are paying on your student loans?

  • How much risk do you need to take in order to make more interest than your student loans?

According to Investopedia, “Approximately 10% is the average return for the S&P 500 since its inception back in 1928.  Adjusted for inflation the “real return” is more like 7%.  Also, worth noting that nearly half of the gains from the S&P 500 resulted from dividends. “

What this means is, if you are to invest your money, you need to invest in a way where the amount of “return” that you earn is more than what you are paying for your student debt.

Before you begin investing your extra money, it is very important to set a goal to have 3-6 months of your yearly income in liquid cash. I had an event last year in my home that was an unexpected expense. By having extra money for me to use, I was able to pay it without having to worry about what account to take from.

When your interest rate is higher than 7%, historically, you can expect to obtain similar returns if you were to invest in an index such as the S&P 500.

Happy Slacking,

Joshua Krafchick, CRPC©, EA