A common question that is brought up by my Gen Y clients is: what do I do about my student loans? The problem is that there isn’t a simple answer.
It really depends on a few things: The amount of student loans in relation to your income; if the loans are public or private; the interest rate on your student loans; and the other goals that you’re trying to achieve.
Prioritizing Your Debt
One of the first things I ask people when they have student loans is if they also have credit card debt. If you have high-interest credit card debt, I always recommend paying that off first, even before focusing on your student loans.
Sometimes people are more concerned with their student loans because the number is bigger than the credit card debt — $30,000 vs. $3,000, for example — but because the interest rate on your credit card debt is often much higher than student loans, you should start by getting out of credit card debt.
Once you’re out of credit card debt, then you should have additional money freed up to go towards paying down your student loans.
Build Up Emergency Savings First
Before making an action plan to attack your student loan debt, make sure you have adequate emergency savings. I generally recommend 3 months of living expenses for dual-earning couples and 6 months of living expenses for people who are single or the primary income provider.
Make sure you have enough money in the bank so that you can sleep at night. Think through some scenarios, like what would happen if your car broke down or a major medical expense came up, or what you would do if you lost your job.
Once you use the cash to pay down your student loans, you can never get it back, so make sure you have emergency savings.
Problem: Huge Student Loan Payments without a Huge Salary
If you have federal student loans and you’re struggling to keep up with your monthly student loan payments, you may want to see if you can switch to an income-driven repayment plan. If you qualify, your monthly student loan payments will be capped at 15% of your monthly income. I tell people who are on IBR plans to set up automatic payments so that they are never late and never miss a payment. Missing a payment can disqualify you from this program, so be very careful to always pay on time.
There is also Public Service Loan Forgiveness, in which your federal student loans may be forgiven after 10 years if you work at certain non-profits or for the government.
Bankruptcy Won’t Help You
Student loans are very rarely discharged in bankruptcy, so unless your situation is dire, it’s worth it to figure out a plan to pay them off. If you are facing extreme circumstances, you can learn more about student loan cancellation, deferment and forbearance from this article on Nolo.com.
Public vs. Private Student Loans
Public loans have a fixed interest rate, whereas private loans often have variable interest rates. Since interest rates are extremely low right now, your private student loans may have a lower interest rate than your public student loans. However, I still recommend that you try to pay off your private loans first because you will have very few options if you experience a hardship.
If you choose to refinance your student loans, you can trade both your federal and your private loans for a private loan with different terms. Learn more about refinancing here.
Focus on Higher-Interest Student Loan Debt
If you’re down to federal student loans only, I generally recommend that you start by paying off the higher-interest rate loans first, because this will save you the most money in the long run.
Start by paying extra on one loan while paying the minimums on everything else. Once you pay off that loan, apply the full amount that you were paying towards the next loan. Some people choose to do this until all of their student loan debt is paid off.
Start Saving For Retirement, Even When It Feels Far Away
Sometimes, Gen Y is so focused on paying off their student loans that they forget to focus on saving for retirement. I think this is a mistake. It’s really hard to suddenly start saving aggressively for retirement late in your career. It’s important to start saving for retirement with your first job, especially if your company benefits include a 401(k) match. Make sure you contribute enough to get your full company match while you’re paying off your student loans. If you don’t, you’re giving up free money!
Continue to Focus on Your Financial Priorities
If you’ve paid off all of your student loans that have an interest rate higher than 5%, it might be a good time to turn your focus on your other financial priorities. As you free up cash, I recommend that you apply that money to your financial priorities — whether that’s retirement, emergency savings, or saving for a down payment on a home.