A new approach to student loan debt...diversify

Please note, this blog was originally posted on my personal site (www.TydlaskaCFP.com) back on 9/4/2015.


Quick Hits:

  • Given today’s low interest rate environment, a variable rate student loan may make sense for you

  • Use this calculator to determine how fast, and by how much, interest rates need to rise to be worse off with a variable rate loan 


Congratulations to the graduating class of 2015! We have a new bullet point to add to our resumes:

We can all commiserate together over the next 10 years while we service this record setting debt. As our six-month grace period is quickly coming to an end, many of us are wondering, what is the best strategy to pay down this good debt?

Offers to refinance student loans are popping up every day from lenders such as SoFi, CommonBond, and Earnest. These companies advertise low interest rates, flexible payment options, and thoughtful customer service. If you decide to refinance your loans, one of the biggest questions you will face is “Do I refinance with a fixed rate or a variable rate loan?” While this decision depends on your personal financial situation, tolerance for interest rate risk, and job security, the following questions may help you decide which option is best for you. 

A fixed rate loan may be right for you if you answer yes to the following questions:

  • Do you want to lock in your payment amount for the entire term of your loan?
  • Are you planning on holding your loan for the entire term of the repayment period?
  • Do your finances keep you up at night?
  • Is your go-to dish chicken parm (a good, albeit safe option)?

A variable rate loan may be right for you if you answer yes to these questions:

  • Are you comfortable with payments that will change in the future?
  • Do you want the lowest initial interest rate and monthly payment?
  • Are you able to pay off your loans early (thus shortening the term of the loan and decreasing your exposure to interest rate risk)?
  • Do you prefer Sushirrito?

The case to diversify:

If you are having trouble picking just one loan type, you can refinance with a mix of fixed rate and variable rate loans. I currently carry a 50/50 mix of fixed and variable rate loans because I am comfortable taking on the interest rate risk of a variable rate loan. The interest rate on my fixed rate loan is 6.21% and my variable rate is 3.95%. In order for me to be worse off with a variable rate loan, the average loan balance has to be subject to an average interest rate of more than 6.21%. (I walk through my assumptions of my own situation at the bottom of this blog post.)

To do some scenario planning, I created this excel calculator. This calculator will help answer the following questions:

  • How does a variable rate loan compare to a fixed rate loan in a rising rate environment? 
  • How much could my monthly payment increase if interest rates rise?
  • What if interest rates rise slowly?
  • What if interest rates rise quickly?

What about an interest rate spike?

One concern in the financial markets is the Federal Reserve has been considering raising interest rates. This has been a concern in the market for well over five years. Given the acute focus on interest rates, and the impact an increase would have on the shaky global economy, it is unlikely the Fed will raise rates quickly. The Fed may not even raise rates at all in 2015.

As a point of reference, according to the St. Louis Fed, the last time the effective Federal Funds Rate was below 1% was back in July of 1954. As you can see from Chart 1, it took over 10 years for rates to rise above 4%.

It is worth noting the interest rate on your student loan is tied to LIBOR and not the Federal Funds Rate. But as you can see from Chart 2, LIBOR and the Federal Funds Rate move almost completely in lockstep.

Lastly, the interest rate on a variable rate loan is often capped. As of 8/26/15, the variable interest rate at Earnest is capped at 8.95%, 9.95% or 11.95% depending on the term of your loan. At CommonBond, the interest rate is capped between 8.99% and 12.99%. So it is possible that the total payments with a variable rate loan would still be lower than a fixed rate loan even if the interest rate reaches the cap.  

My Assumptions:

  • I assume the Fed will begin raising interest rates next year (12 months from 9/4/2015)
  • I believe the Fed will take a measured approach to raising the rates and will slowly increase them over the subsequent eight years
  • The interest rate on my fixed rate loan is 6.21%
  • The current interest rate on my variable rate loan is 3.95% and the cap is 8.95%
  • The term of both loans is 10 years
  • For the model, I assumed the student had $50,000 in student loan debt and refinanced their loans with a mix of 50% fixed rate loans and 50% variable rate loans

Commentary on the Results:

In this scenario, diversifying with a mix of variable and fixed rate student loans could potentially save $991 in interest payments. However, you can run a variety of scenarios based on your situation and interest rate assumptions. For example, you could assume that interest rates begin to rise next month and you reach the interest rate cap on your loans within six months. 

 

Please leave your comments or questions below as I would love to hear your feedback.

 

Views expressed in this post are that of Shawn Tydlaska, CFP(r), MBA. Shawn is a Certified Financial Planning pro and graduated from University of Michigan Ross School of Business. This blog is for informational purposes only and should not be considered a recommendation or endorsement to a particular investment or strategy.