Pay Off Student Debt Early?
August 21, 2012
Student loan debt has been in the news a lot lately and not for any good reasons.
Some see student loans as being the next potential bubble to blow, not unlike the mortgage loan mess of a few years ago (that’s still being worked out even now). Will they go the way of mortgages and have a full blown meltdown?
Who knows? But one thing is certain, millions of young adults are having to deal with the weight of some pretty large debts very early in life and that will impact them for years to come.
No matter how we might want to sugarcoat the virtues of student loans, they are still debt, and have all the same potential pitfalls of other, less highly regarded loan types. And we should want to pay them off for all the same reasons—elimination of the monthly payment, peace of mind, lowering the cost of living or just being free to move forward in life.
But I think there’s one reason that stands above all others as the reason to pay off student loan debt as early as possible: student loans can be the beginning of the debt treadmill.
Getting on the debt treadmill early
Once you start borrowing money—especially before you’ve even earned any—you’re setting up a negative dynamic in your financial life. One debt, your student loans, will lead to another debt, and yet another and so on. Ironically, this will be especially true if your college graduate salary isn’t quite what you hoped it would be.
Here’s the basic problem: student loans are massive, unsecured loans, taken out by people very early in life. According to the Project on Student Debt, the average student loan balance is now over $25,000 per student, and there are many who owe substantially more. Stories of people who owe over $100,000 are hardly uncommon.
To owe that much money when you’re in your early 20s and just coming out of the starting gate of life is a lot to handle. But you’ll also need money to pay for all the other start up expenses in life, such as a car and an apartment and everything that goes into it. Where will that money come from? All too often: D-E-B-T. And then you’re on the debt treadmill. Unfortunately, it’s much easier to get on a debt treadmill than it is to get off.
Juggling multiple debts
One of the reasons it’s so hard to get off the debt treadmill is that income doesn’t match up well with debt. Let’s say you graduate from college, and the two major components of your financial profile are a $50,000 salary, and $50,000 in student loans. On the surface it looks like an even exchange, but it’s really not. Income, you see, has claims against it, like payroll taxes, benefits, debt service and general cost of living. Debt, on the other hand, just sits out there staring at you as a giant whole number, free of any reductions except what you are able to pay into it.
Let’s look at some typical expenses and what they do to your $50,000 salary.
- Income taxes—roughly 8% for FICA, 10% for federal income taxes, 5% for state income taxes, or 23%. That’s $11,500.
- Health insurance contribution (employer pays 50% of $3,000), $1,500.
- 401K contribution, 6% because employer matches 50% up to this point–$3,000.
- Rent of a modest apartment at $800-$850 per month, say $10,000 per year.
- Utilities, internet/cable, cell phone, etc, $250 per month, or $3,000.
- Student loan repayments, estimate 1% of the $50,000 balance, or $500 per month, $6,000 per year.
- Loan repayment for a modest car, $350 per month, or $4,200 per year.
- Car insurance, repairs, maintenance, gas, about $4,000
- Credit cards totaling $10,000 paid for apartment furnishings and a post graduation trip to an exotic destination, $250 per month, or $3,000 per year.
If my math is correct, the total of all of these predictable claims on your salary is $46,200. That will leave you with $3,800 per year, or a little over $300 per month, to pay for food, clothing, entertainment, haircuts and everything else you need in life. What it won’t leave is money for savings or for debt reduction.
How quickly do you think you’ll pay off your student loan with a financial situation that’s even close to this? What are the chances you won’t borrow even more money to pay for what your salary doesn’t cover?
This is why people have student loans into their 30s and 40s, and why they can never get out from under.
Dig out from under before you dig any deeper
The counter argument to the admittedly dreary profile above is that you’ll be able to pay off your student loans out of the higher income you’ll earn later in your career. That may be true, but it’s equally true that a career setback or the birth of a child or any number of other life events can easily get in the way of that assumption.
So what’s the solution? Pay off your student loans while you’re young and single and don’t have any obligations in life.
Instead of renting an apartment, live home with your parents, share an apartment, or rent a room for as long as it takes to pay off your loans. Instead of buying a new car, buy the cheapest one you can afford without taking a loan to get it. Delay contributing to your company 401K—once your student loans are paid you’ll easily make up for it.
Using the example above, freeing up an extra $10-12,000 per year can enable you to pay off $50,000 in 4-5 years, or roughly the time it takes to pay off a typical car loan.
You may want to free yourself to start your own business, to take in interesting (but lower paying) job, or even to take a less lucrative job in a different location. By paying off your student loans you’ll be able to do any of those and more.
Student loans may have been the only way you could get your education. But just because you have them doesn’t mean you have to keep them. Take what ever time and efforts you need to get rid of them—before life starts getting more…complicated.
Last updated by.
All posts by Ben Edwards