Recently a reader wrote in explaining that she’s going through the refinancing process. Like many students, she incurred approximately $170K in student loan debt and has a starting salary of $140K. Those are pretty typical numbers based on my experience.
Despite the “normal” amount of debt, she quickly realized that there was nothing “normal” about paying more than $11,000 in interest each year. Worse, even a $140K salary can only do so much damage on students loans when you need almost a $1,000 each month just to clear the interest hurdle before you can start to reduce the principal balance.
In these situations, refinancing is a no brainer. I meet lawyers all the time who are switching into these low 3% variable rates. You’re all so lucky. When I graduated law school, there were no fancy loan refinancing companies. The best you could do was consolidate your federal loans. Many people mistakenly thought they’d get a better deal, but it often made the interest rate slightly worse. The only benefit of consolidation was that you had one loan to pay instead of eight.
Being able to cut your interest rates in half is a miracle and one that will save you thousands of dollars over the course of your loans (perhaps even $10s of thousands of dollars).
In a previously article, I wrote about whether you should select a variable or fixed rate when deciding to refinance. I won’t rehash the arguments here, but suffice to say that the variable rate wins three out of four times and is probably the way to go for you too.
Picking a repayment term
This particular reader wanted to discuss term length. Most of the student loan companies give you options. The typical term lengths offered are 5, 7, 10 and 15, although some companies offer smaller or larger term lengths. In each case, you pay a slightly higher interest rate if you take a longer repayment term.
On the other hand, a longer team means smaller monthly repayment amounts, which makes managing your cash flow a little easier. These smaller monthly repayments are attractive because even people who plan to aggressively pay off their loans can benefit if they have a few months where they might only make the minimum payment.
Student loan companies that offer longer terms and therefore lower monthly payments are attractive to risk-adverse lawyers (i.e. all of us). We’re trained to think of the many ways things can go wrong and naturally we want to reduce the risk, both for ourselves and our clients.
But I’ve found that lawyers aren’t always the best at evaluating risk. We’re trained to identify it and avoid it, but usually the clients decide whether to take the risk or not.
In deciding which term length to pick, it’d be helpful if we could conceptualize the risk.
There’s a risk that you lose your job and income. There’s a risk that you have some unexpected expenses in one month. There’s a risk that something bigger happens in your financial life that prevents you from making student loan payments. In these situations, you’ll be better off if your monthly payments are lower as it gives you more flexibility.
But it’s important to understand that this risk exists no matter what. It’s not like you can wave a magic wand to make it go away.
So the question is, who should take on that risk?
Either you can take it or you can give it to the student loan company.
If you take on the risk by agreeing to a higher monthly payment, the student loan company will reduce their interest rate. Higher monthly payments means you’ll pay off your loan faster, reducing the possibility of something like a death or disability that could lead to your inability to pay the loan. By reducing the risk for the bank, they charge a lower rate.
If you let the student loan company take on the risk by choosing a lower monthly payment, the student loan company will increase their interest rate. Lower monthly payments means it’ll take you longer to pay off your loan, increasing the possibility of something like a death or disability that could lead to your inability to pay the loan. By increasing the risk for the bank, they charge a higher rate.
Make sense? The risk is there. It’s all about who takes it on.
Once you think about it in these terms, the decision should crystalize for you.
You should take on as much risk as you’re comfortable with.
In my view, the risk discussed above is the best kind for you to take on because it’s almost all within your control.
Worried that you’ll lose your job and income? Focus at work and save up an extra cushion to make student loan payments for a few months should the worse happen.
Maybe you’re concerned that one month you’ll have some unexpected expenses and not be able to meet your minimum monthly payment? Save up an emergency fund and get better at budgeting your income.
In both cases, you’ve taken steps to reduce the risk (steps that the bank could never take) and consequently will be rewarded by paying a lower interest rate.
Now, this doesn’t mean that you tie yourself in knots taking on risk after risk. You can actually boil it down into numbers. If the difference between two terms is a 0.25% increase in interest, the student loan companies have priced the risk for you.
Let’s consider two examples. The reader owes $170K. Let’s say option 1 is a comfortable monthly repayment and option 2 is a uncomfortable repayment, but that both payments are “doable”. In this hypothetical, the difference between the two options is a 0.50% interest rate. Your risk calculation is simply $170,000 x 0.005 = $850/yr.
Now it’s up to you to decide. Would you rather pay $850 a year for the life of the loan to offload the risk and have the comfortable monthly payments? Or do you think it’s worth it to save the $850 each year in order to manage the risk yourself? The decision is yours.
Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He is always negotiating better student loan refinancing bonuses for readers of the site.
Can you provide me with a link to your previous article where you explained why variable rate is better than fixed? Because interest rates have been rising, my co-worker who is looking into refinancing said that he is considering fixed rate instead. Thx.
Sure, I’ve linked the article below. If he’s planning on paying it off quickly (2-3 years) he’s almost guaranteed to do better with a variable rate.
Related: Should I Choose a Fixed or Variable Rate for Student Loans?
I personally chose to go with a variable rate and a 5 year term. This gave me a starting interest rate of 1.93% and by the time I paid off my loan, it had risen to 2.16%. Still very low.
Totally agree with your comment. If you’re going to pay off your loans in 1-3 years, going with a variable rate and a 5 year term period is going to be your best bet. Even with rates rising, you’ll save money because your interest rate is unlikely to rise above a certain level, and even if it did, you’d probably be nearing the end of your student loan payments anyway.
Absolutely. As you said, it’s important to understand that even if you expect interest rates to rise you’ll save money because at first you’ll be paying interest at a lower rate (when your balance is the highest). By the time to rate rises to equal the same rate you would have received had you chosen the fixed option, your balance will be significantly lower if you’ve been aggressively paying off the debt, thus generating less interest overall.
I also picked a 5-year variable rate loan pay off when we refinanced my law school loans. The interest rate was low (around 3% if I’m remembering right), but we paid it off in a bit over a year. All things considered, it didn’t save too much money since we paid off the loans so quickly. If you are planning on killing your loans quickly it’s mostly irrelevant how high the rates are (within reason of course). Complex analysis about interest rates only matters if you’re planning to keep your loans around for long enough for it to matter.
Agreed. No need to go into complex analysis, just refinance the loans to get the best rate you can and move on. I might quibble with you a little about it being “mostly irrelevant”. Many lawyers can cut their interest rates in half, dropping from ~6% to ~3%. Even if they supercharge their payments and pay everything off within 1-2 years, a refinance is going to result in saving thousands of dollars.
What I tell clients when doing student loan consulting is if you have the capacity to repay your student debt in three years, then it’s ok to go with the variable rate. If interest rates suddenly increased, then you could simply pay more aggressively on your loans and avoid huge interest charges.
However, for folks who are cash flow constrained because of family, mortgage, or whatever the reason, variable is rarely the right way to go. That 3 year payoff rule really works, because if you’re planning on keeping the debt around for 10-15 years, it only takes a 0.25% a year increase in rates for the fixed to look comparable. If it’s more aggressive than that, you could have a cash flow constrained individual with higher payments.
It’s not only OK to go with the variable rate, it’s the way to save money. It’s not that if interest rates suddenly increase you could simply more pay more aggressively, it’s that by the time interest rates increase to the point where they’re higher than what you would have had if you had chosen the fixed rate, your outstanding balance will be substantially smaller so the hit won’t be nearly as meaningful.
Consider a simple rising interest rate scenario where a borrower had to choose between a fixed 4% and a variable 3%, where interest rates rise 0.5% per year and the borrower intends to repay a $100,000 debt in four years.
Year 1: $100,000 * .03 = $3,000
Year 2: $75,000 * .035 = $2,625
Year 3: $50,000 * .04 = $2,000
Year 4: $25,000 * .045 = $1,125
Total Interest Paid: $8,750
Year 1: $100,000 * .04 = $4,000
Year 2: $75,000 * .04 = $2,960
Year 3: $50,000 * .04 = $2,000
Year 4: $25,000 * .04 = $1,000
Total Interest Paid: $9,960
By choosing the variable rate you’ve saved $1,210 without having to resort to more aggressive payments.
If you plan on paying off the loans within 3-5 years (which is what I recommend), then the variable rate is the way to go. If something happens (e.g. you lose your job and can’t find a replacement job with a similar income), I’d just refinance at that time into a fixed rate loan. I certainly wouldn’t plan my repayment strategy around this possibility though.
Totally agree for someone in Big Law that has their finances in good order that variable is the way to go.
I’m just saying I often run into folks who might have $150,000 in debt but only a single $90,000 income. They have 2 kids, and they want to refinance and pay it back over 10-15 years because the math looks better than income based repayment. That person would be totally screwed if you had some inflation and short term LIBOR rates went significantly higher.
Sofi and Common Bond cap their variable rates at 9%, but some like MEFA set the cap at 20%, so definitely agree your readers Josh should be doing variable, but the ones in the mid and small sized law firms with more modest paychecks need to just make sure they have the cash flow to back it back fast before jumping in. Great post btw
Considering that we’ve been in a low interest rate environment for 7 years, I think it’s prudent that all borrowers understand that they’re just risk shifting. If they want the bank to take the risk of rising rates, the bank will gladly do so but will charge for it. If they want to take on the risk themselves, they can do so and save money (but take the chance that the risk materializes).
Ultimately this is one of those personal finance decisions that’s personal for the borrower to decide. There’s no right answer (except for those aggressive payers). I’ve seen plenty of lawyers at mid and small sized firms with lower salaries decide that they are going to ruthlessly go after loans. I’ve also had readers tell me they’ve picked 10 year fixed rates because they felt more comfortable with the risk balancing.
I can’t fault either of those paths, though I’m confident that if you can buckle down and live like a law student for 3-5 years after graduation you’ll set yourself up for a great financial future, since as you pointed out the key here really is cash flow!