No, You Should Not Pay Down Your Federal Student Loan Until September 2021
You have a choice: pay me $10,000 right now or pay me $10,000 in one year.
This is not meant to be a trick question.
For all that is good in the world, I hope you will choose to pay in one year. You would be getting a 0% interest rate!
If you wavered in your response, you’re not alone. Society has made people believe that debt is bad and needs to be eliminated as fast as possible. But that’s wrong!
Debt is not inherently bad. It’s only as bad as the daily interest is high. That means the goal should not be debt elimination, but interest minimization. And an interest rate can’t get any lower than 0%.
Before you start saying “a 0% interest rate never happens,” realize that is exactly what’s happening right now for federally funded student loans. In March 2020, the government paused all interest and payments on federal loans which includes Direct Stafford loans (subsidized and unsubsidized), Direct Plus loans for parents and graduate students, and Direct Consolidation loans. In January 2021, the moratorium was extended until at least September 30, 2021.
This can raise a lot of questions about what people with student loans, who are fortunate to still have financial stability, should do.
After reading a story about a millennial couple who repaid $118,000 of student debt during this 0% interest rate period, I felt compelled to write this article.
There is no reason why the couple should have repaid their debt in full while there is a $0 cost of borrowing. Instead, they could have put that money into an interest earning savings account that could have yielded them $500* before September 2021, when the government may lift the moratorium. Sure, $500 isn’t that much money, but why leave it on the table?
Psychological Perception of Debt Freedom
Some people might say “the psychological weight lifted by knowing you’re debt free is totally worth it, even if that means giving up $500.”
The psychological perspective is worth giving up on cold hard cash?
No, what they’re really saying is they worry about spending the money on frivolous things before it gets applied to their outstanding debt. This could be a very real concern, and I have seen it happen. But doesn’t that mean this thought process gets them dangerously close to falling down the debt rabbit hole again? Just like with dieting, just putting the food out of sight will only protect you for so long from binge eating. At some point you need to make the mindful decision to avoid eating (or spending) to excess.
That’s why I don’t buy the “psychological weight” argument for debt repayment strategies. Even though emotions play a large part in our spending habits, change starts when we become mindful of our actions. Otherwise, individuals who continue following emotional-driven responses (or repayment strategies) will be more susceptible to repeating their mistakes.
What Should Borrowers Do Until The Moratorium Lifts?
For borrowers with federally backed student loans, the interest rate is 0%. Here are your options if you are:
a. In the middle of your accelerated debt repayment journey:
Keep going but make one key change: make payments into an interest-earning savings account instead of to the loan servicer. A variety of institutions are offering 0.50% with no minimum deposit and no minimum time frame. Every time that you would have paid your loan servicer, you will make a deposit into this interest-earning savings account. Once the moratorium ends on September 30, 2021 (or maybe later, if it needs to be extended again) you will be able to withdraw the funds and pay it toward your loans. (In a future post I will explore how to determine how to allocate your payment if you have multiple loans).
b. A borrower with outstanding interest on your loan:
This outstanding interest happened because your minimum monthly payments were not enough to pay off the monthly interest in full, so every month you had interest left over. This is common with income based repayment plans. It will make a huge difference to the cost of your loan if you can at least pay down the outstanding interest when September 30, 2021 rolls around. To figure out how much outstanding interest you have, you can either call your loan servicer or log into your online account (here is a list of them) and view loan details. Make a plan for how much you can contribute to a high yield savings account on a monthly basis, and then make one large payment to your loan provider before the moratorium lifts (in September, or later).
c. 2020 Graduate with federal loans that are still in deferment:
Please don’t forget about your loans! If you have not received any emails from your federal loan servicer, get in touch with your school’s financial aid office. If neither you nor your guardians made payments to your loans while you were in college, then you have unpaid interest on your loans (unless you had federally subsidized loans). After you determine what this amount is, make a plan for how much you can contribute to a high yield savings account on a monthly basis until September 2021 (or later, if the moratorium gets extended). Right before the moratorium lifts, you will withdraw the funds from the savings account and make a payment to your loans. It will make a substantial difference if you can at least pay down this interest before the moratorium lifts, otherwise it will capitalize on your principal and can cost you tens of thousands of dollars more in cost of borrowing.
d. Enjoying the payment-free life and not thinking about student loan payments:
If you are one of the lucky ones to still have a stable job and income, please don’t squander it. This is an uncommon opportunity to get more value out of your money and save yourself on significant interest. But just like I suggested for the other types of borrowers, payments shouldn’t be made to your loan servicer until the moratorium is about to be lifted. Find other ways to grow the payments that you otherwise would have made to your loans and then make one large payment before the moratorium lifts.
e. Feeling the economic effects of COVID-19:
It is 100% okay to focus on the health and safety of yourself and your family. Don’t feel pressured into worrying about your loans right now. If your circumstances improve before the moratorium lifts, you can work on building (back up) your emergency fund in a high yield savings account and, depending on how much you have in the account by September, you can consider putting some of the funds to your loans at that time.
*$500 is calculated assuming a 0.50% APY (Annual Percentage Yield) savings account and $100,000 invested for 1 year. Since they paid off $118,000 of debt by December 2020, I’m assuming that they would have had $100,000 by September 2020.
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