If you have a student loan from a private, non-governmental institution, you know it’s a special (and potentially wild) animal. Private student loans often have higher interest rates, some have variable rates, they generally can only be consolidated under private lenders, and they don’t allow you to ask the lender to defer or forbear payments, or appeal for forgiveness.
Even if your private loans have a repayment grace period (some do, some don’t), interest is likely still accruing. In fact, interest may have been accruing over the entire lives of the loans. Because many private loans capitalize interest at the end, which means paying interest on the interest, too, the total amount you’ll pay for the loan is higher.
To avoid having your loans capitalized, you should look for ways to pay student loans before that happens. The question is, should you give priority to repaying these loans over your other financial commitments? Before you decide on which way to go, take a look at the pros and cons of loan repayment via funds from emergency savings, retirement accounts, home equity loans, or by consolidating all your student loans.
1. Using emergency savings
A definite no.
An emergency savings account with funds adequate to cover several months’ worth of living expenses should be dedicated to helping you manage unexpected crises and misfortunes. “Emergency” is the key word — and paying down debt doesn’t qualify.
First, all debt is not equal. Some of it can actually work for you. For instance, debt with relatively low interest rates, and tax deductible potential, such as a mortgage loan or a student loan, falls into the “good” debt category. High interest debt such as credit cards and car loans are definitely in the “bad” debt category. It’s the most costly, especially over time. Plus, you’re borrowing to own something that depreciates. For example, what happens the minute you drive a new car off the lot?
Obviously your goal should be to pay off the bad debt as soon as possible. But good debt can actually be a helpful financial tool. It certainly cannot be considered an emergency issue, and can be paid down systematically.
2. Using your retirement accounts
A probable no.
You’re very likely making more money on your retirement savings — if you take into account compounding and tax breaks — than you’re paying in interest on your student loans. As long as you can pay a bit more than the minimum monthly payments on your student loans, keep saving for retirement.
If you were to withdraw from your retirement account without an exception to the 10 percent early withdrawal penalty, you would expose yourself to both income taxes and penalties. Even if there were an exception, you’d still have to pay income taxes, which, depending on the amount and your income, could be at a higher marginal rate than you are currently paying.
If you’re insistent on getting rid of the student debt as soon as possible, consider reducing the amount you contribute to the retirement plan (but not below the amount that gets you the maximum employer match) and transfer the unused part of your contribution to higher monthly payments toward the student loans.
3. Using home equity loans
A possible yes.
Using a fixed rate home equity loan to pay off your private student loans may or may not be beneficial for you. Many private student loans have variable interest rates, which can increase or decrease, while fixed rate home equity loans have locked interest rates.
If variable interest rates are falling but you have a fixed rate, you “lose.” But having a fixed rate when variable interest rates are on the rise may allow you to “win.”
Applied to the payoff of your student loan debt, this option depends on which way the credit market is headed and how your student loan interest rate compares to your potential interest rate on a home equity loan. If you’re eligible to deduct student loan interest from your taxes, don’t forget that may make your effective interest rate on those loans lower.
4. Consolidating your student loan debt
A likely yes.
While it’s not possible to use the federal loan consolidation program to combine your federal and private loans, it is possible to consolidate federal and private loans with certain private lenders. Be sure you’re not going to lose anything important to you in the way of benefits and protections on your federal loans that do not transfer to private lenders. For example, for people who choose careers in public service, education or the military, there are hardship repayment plans on federal loans.
But if these issues aren’t a concern, consolidation offers several potential advantages. Among them are streamlining your bill payment process, extending your repayment term, lowering your interest rate, switching from variable to a fixed-rate, lowering the monthly payment amount, getting into an alternate repayment plan, and borrower benefits like discounts on interest rates for automatic payments and/or paying on time.
Some of the potential disadvantages of consolidating your loans can be paying more in total interest, having a larger total loan repayment amount, extending your loan period, losing borrower benefits from your current lender or having to repay borrower benefits, and the loss of your grace period (if you consolidate loans during their initial grace period).
Tips for repayment
By the way, don’t forget the following considerations in paying off your loans.
If you choose not to consolidate your student loans, here are some tips on repaying them individually. Always pay more than the minimum payment amounts. Set priorities when you have multiple loans — pay your private loans first because they likely have the higher interest rates and stiffer terms. And remember, you have the right to prepayment without penalties on educational loans, federal or private, because of the Higher Education Opportunity Act of 2008.
These suggestions should help you find ways to pay student loans, reduce the total amount that you ultimately pay for these loans, and set you free to move on with your financial life.