By Gail MarksJarvis
If you’ve just finished college and are spooked by your student loans, you probably don’t have to be.
Assuming you haven’t already committed a big student loan borrowing mistake, like piling up loans without finishing college or borrowing extensively from private lenders rather than the federal government, there’s no rush to pay off your loans. What’s more important is paying them off wisely, and avoiding one of these four deadly college debt sins.
The first sin: Hanging on to private loans.
If you have Stafford or Perkins loans, those are federal government student loans, the most lenient student loans you can get. Private loans typically cost more and are tougher on borrowers. If you are going to try to get rid of student loans fast, retire the private loans first.
With the federal loans, you will be paying interest but you probably will be OK paying them off over the next 10 years. There’s a rule of thumb in student loan borrowing: Don’t have a total in loans that is greater than your starting salary out of college. And since the average borrowing among recent graduates has been $30,000, and the average starting salary reported by the National Association of College Employers has been $47,000, the numbers work.
Of course, many college graduates don’t have jobs when they graduate or have pay far below the average. But if you have federal Stafford or Perkins loans, you still don’t need to fret. With these federal loans, if you run into trouble making monthly payments because you lose your job or your job doesn’t pay enough, the federal government will cut you a break, reducing your payments temporarily.
Private loans usually don’t give you this type of break.
Keep in mind that if the government cuts you a temporary break on your Stafford loans with what’s known as income-based repayment, or with a deferment if you have no job at all, that doesn’t mean you are off the hook forever. You may end up paying off your loans for a longer period than 10 years, and that will add to your interest payments. That will mean that as you pay extra interest you will have less money to spend on everything else you might need or want.
The second sin: Asking for a long repayment plan.
Some recent college graduates will be tempted to ask for a repayment plan that lets them pay off their loans over 20 years instead of 10, so their monthly payments are more livable.
Here’s why you should avoid long repayment plans if you can. If you have $30,000 in loans and your interest rate on all of them combined is 4 percent, your monthly payments will be $304. As you pay off your loans over 10 years, you will pay a total of $36,448. That’s your original $30,000, plus $6,448 in interest.
But say $304 a month is terrifying, and you ask to repay your loans over 20 years instead of 10. Then, your payments will be just $182 a month, but the interest you will pay over time is more than double, $13,630. That’s $13,630 you won’t have for a car, a home downpayment, or for fun. Over 20 years you will pay a total of $43,630.
Since the government cuts you a break if you run into trouble and can’t afford your student loans, starting out with a 10-year repayment plan makes sense.
The third sin: Not paying a little extra when you can.
College graduates typically make $600,000 more over a lifetime of work than people who didn’t go to college. So once you land a college degree-related job, your pay should pick up as you get established in a career. Then, you should consider paying more than the minimum monthly payment on your student loan each month. That will get rid of your loans faster and cut down on the interest you will pay over the life of your loan.
Typically there are no penalties for paying off student loans fast, so anything extra you can muster beyond regular monthly payments helps. Paying a little extra is especially important if you have private loans with high interest rates. And if you have credit card debt, getting rid of that high-interest debt should be a priority.
The fourth sin: Paying off student debt too quickly.
While paying extra each month on student loans can be a good strategy, don’t take this too far. Some people become obsessed with paying off student loans too quickly, devote more than they should to debt payments, and as a result fail to develop emergency funds that can cover unexpected expenses like a car repair or a dentist bill. With no emergency fund in place, these individuals may start racking up credit card charges that are destructive to their ability to get ahead.
So besides paying federal student loans on a typical 10-year repayment plan, and getting rid of private loans and credit card debt if possible, borrowers should be setting aside some money from every paycheck in an emergency fund.
Establishing an emergency fund is more important than trying to rid yourself immediately of federal student loans. As a rule of thumb, starting with your very first job, you should be trying to save 10 percent of pay. Over time, you should build an emergency fund that is equivalent to three to six months of pay.
If 10 percent isn’t doable, a smaller amount will help, as long as you make it regular part of your monthly budget, not an afterthought.
Good savings habits go beyond establishing an emergency fund. Even in your 20s, it’s time to start saving for retirement. If you have a job and you have a 401(k) plan, do not skip contributing to it. This is especially crucial if your employer gives you matching money. That’s free money that your employer gives you as a reward whenever you put some of your paycheck into a retirement saving plan at work.
Say you are 25, and making $35,000. You get one of the common matching deals from your employer: 50 cents on every dollar you contribute to the 401(k), up to 6 percent of your salary. You decide to go for every free penny you can get, which is wise. Never pass up free money. So that year, you contribute $2,100 of your pay to the 401(k) and your employer puts in $1,050 of free money.
And let’s say that over your next 40 years of work you keep putting in 6 percent of your pay as you get annual raises and also keep getting the matching money. If it grows the way it has historically in a mutual fund known as a target-date fund in a 401(k), you should have over $1 million when you retire.
If 6 percent isn’t possible, do a lesser amount, but do it automatically month after month, and when you get a raise add to it. Don’t wait until your student loans are paid off, because you will lose valuable years that make it possible to hit the $1 million mark.