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Facing Those Student Loans

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By John Vineyard

If you've recently finished grad school and landed your first teaching job, congratulations. All that hard work has paid off, and now you're ready to tackle much larger financial worries.

As you get ready for that first semester of teaching, the initial payments on your student loans begin to come due, six months after graduation. According to a federal study on collegiate aid, students who earned doctorates in 1999-2000 had accumulated an average debt of $24,078; students who earned professional degrees had an average debt of $61,417 at public institutions and $73,533 at private ones. About 50 percent of doctoral recipients borrowed to finance their education, while roughly 80 percent of those earning professional degrees went into debt. These levels represent an increase in debt since 1992, when the average doctoral recipient owed $11,191. There's no reason not to expect this trend to continue, so be glad you're done now.

Borrowing levels vary widely by field, but it's easy to picture your having more than $40,000 in student loans as you begin your first job, and possibly a good deal more. You may be lucky enough to be making many times what you've ever earned before, but given your loan debt and the other obligations of moving and setting up house, that new salary may seem a lot less than it looked at first.

What Now?

More than anything else, you need to organize your spending habits. Study the terms of your loan, and if it is not a habit already, budget your income and expenses. Getting a good handle on this process will pay off tremendously in letting you worry about the bigger things. The higher your student-loan balance, probably the greater the urge you're going to feel to unshackle yourself and breathe a little freer. Should you just pay your student loans off as quickly as you can?

Let's suppose that you're ready to take the next step. You have expenses more or less under control, and in fact, there is going to be a bit of discretionary income sloshing around at the end of the month.

At this point, you need to prioritize. Your first priority ought to be to pay off those high-interest credit-card balances you may have accumulated in graduate school and become what the credit-card companies privately call a "deadbeat," because you pay down the balance every month. Each dollar of a credit-card balance is probably costing you several times more in interest than each dollar of a student loan. If you have any defaulted loans, getting current on them would also be a top priority.

Your second priority should be to accumulate a rainy-day fund that will enable you to avoid falling into more debt traps in the future. Six months of living expenses is often tossed around as a reasonable cushion, although there is no magic number. One of life's mean little ironies is that the tighter your budget, the more you need a rainy-day fund and the harder it is to accumulate one.

Your third priority is to be sure you are maxing out your tax-deferred retirement contributions. I could wax on for whole chapters about this virtue, but your dollar invested in a tax-deferred account has enormously greater growth potential than a taxable investment account, nearly as good a return as the return on paying off your credit card. At the very least, make certain you form the habit of regularly contributing something. The power of compound interest is so great that a dollar invested in your retirement fund during these first years is worth many times more than a dollar invested during your 50s or 60s.

Now let's suppose that you've managed priorities one through three and there is still something left over. Perhaps a kindly uncle remembered you in his will, or you are rapidly becoming an academic superstar. Let's suppose that you could afford to pay the loan off and then really take on some serious indebtedness (in the form of a home) with your new, stronger credit rating. I think we are now at the first stage where we might have a genuine debate, where the mathematics of the thing doesn't yield an automatic answer.

Should you use the extra cash to pay down the student loan ahead of schedule or invest the money in real estate? If you pay off the loan in order to improve your credit, when it comes time to buy a house, you may well end up borrowing more than you owed on your loans, the American appetite for housing being what it is. It's true that you can sell a home to unload a mortgage, while you can never sell off your education. But the terms of your student loan are so generous that it seems a shame to sacrifice a lot of liquidity to accelerate the payment. If you use up your cash to pay down a 3-percent debt just so you can load up on 6.5-percent debt, you'll actually be paying out a lot more interest over many years.

Since new professors typically get at least a six-year lease on that first job, they're often excellent candidates for home ownership. The executive who gets moved every two years can't begin to think about home ownership unless his company agrees to help with the closing costs and maybe cover any capital loss. There's little on the economic horizon just now to suggest that the housing boom is likely to evaporate any time soon, so as long as you buy wisely, that's probably the best move, provided you really want to own a house and can live with the cost. So you may well use your surplus to buy a house before accelerating payments on your loans.

A Taxing Situation

Several recent developments make it even more attractive to hold on to those student loans as long as you can. This July 1, the interest rate on Stafford loans is dropping to 4.06 percent from 5.99 percent, since they are keyed to the U.S. Treasury bill rate. These are probably once-in-a-lifetime low levels. Thank you, Alan Greenspan. You also get the opportunity to consolidate your student loans and lock in this new rate for the remainder of the term of the loan. There may be further discounts if you sign up for automatic withdrawals. The window to lock in these lower rates lasts from July 1, 2002. to July 1, 2003. (There will be somewhat different rates depending on when you originally took out your loan.)

On top of this, beginning with the 2002 tax year you can deduct up to $2,500 of the interest you pay on your education loans. That could easily be more than all the interest you pay. If you're single and earning over $50,000, this deduction begins to phase out between $50,000 and $65,000, while for married couples filing jointly the income restriction is exactly twice as much. Furthermore, until the tax changes of 2001, you could only deduct student-loan interest for the first 60 months. Now you can go on deducting the interest as long as the loan lasts and as long as you qualify under the income limitations.

What's more, some lenders may allow you to reduce your total payments, if you have more than one loan, by consolidating them. They may also allow you to increase the term of the loan and thereby lower your monthly payments.

Maybe you should have borrowed more!

Some of the issues that will factor into the decision whether to pay down some or all of the student loans before buying a house include the total amount of your indebtedness, the amount of mortgage you could carry while still paying the loan, and the amount of liquid cash you can bring to the table. If you're still fixated on paying down that student loan promptly, consider that it's really an investment in your whole life's earning power, and that's small potatoes compared with what you're likely to rake in over a whole career.

What if I Just Can't Pay?

During the 1970s and 1980s, the government became lax about collecting student loans, and the default rate peaked at 22.4 percent in 1990. Current laws provide for strenuous collection action, and the current default rate is under 7 percent. In some circumstances, you do everything right, and everything still goes wrong. Under some conditions, you can get a deferment on a loan, which puts off interest payments for a time, but the interest will go on accruing and you'll eventually end up owing a larger balance. Some conditions that may permit a deferral are poor health and certain personal problems. Generally you can't get a deferment if the loan is already in arrears. You may also have the option of calling the lender and arranging a change in the shape of your payments, so they are stretched out or increased over time. Forgiveness of the whole loan requires even more drastic circumstances, such as total disability, death, or bankruptcy. Naturally you want to put everything you can in place to increase your odds of being able to continue making those payments.