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Case Study: Student Loan Refinancing

by Matt Jones, CPA
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A recent graduate of my Alma Mater, Miami University, and later Cleveland-Marshall College of Law reached out to me for advice on how to deal with his large student loan balance. We’ll call him Tom. We’d talked in past and I gave Tom basic advice on how to handle some of his financial questions after graduation like:

  • what he could afford for apartment rent
  • whether to buy or lease a car
  • which credit card to choose (and how to avoid getting into debt with it)
  • what insurance to select at work
  • how and why to figure out his credit score
  • what net worth is
  • book recommendations on investing

I’ll cover all of these in additional posts on here as we go, but for now we’ll focus on the most recent conversation: his student loans from undergrad and law school. The total damage: more than $100,000 and his interest rate was high – 7.8%.

Most college graduates leave school with student loans and even more if you go to graduate school, law school medical school, etc. If you fall into this majority, it’s nothing to be ashamed about. Hopefully you enjoyed your time in school, received a quality education, and graduated with a degree that helps you succeed. However, you might consider whether the amount of interest you’re paying is appropriate.

I remember when I was in school, I didn’t know or care about interest rates. When I graduated I didn’t really care about interest rates either. But, it finally hit me, about six months after graduation… I cared about interest rates, because I noticed a large portion (about a third) of the monthly payment I made on my student loans went toward interest. WHAT THE??

Student Loans Basics

Student loans typically have interest that accumulates each month. The next monthly payment will go toward the interest first, then the actual loan amount (the principal- in Tom’s case, $100,000). If the interest rate is higher, there’s more interest to pay for each month.

The other factor is how quickly you are able to pay. If you defer your loans like many people do, the interest keeps accumulating before you make any payments and it can become pretty significant (7.8% x $100,000 equals $107,800 at the end of a year, or an additional $7,800 Tom now owes). If you pay more frequently, say, twice per month, the interest won’t have as much time to accumulate, reducing the total amount you pay. Over time, and by making larger payments, the portion going toward interest for me reduced to about a tenth of the payment, from about a third.

So, back to Tom. Tom graduated law school and decided not to go to a big law firm, so he wasn’t able to pay off his loans as quickly as he might have. The bigger issue was that his loans were from private lenders and the interest rates were near 8%. If you’re familiar with student loans you may recognize these are in the higher range. Since a bank can always take your car or home if you don’t pay, but they can’t take your college degree, interest rates on student loans tend to be higher than car or home loans since there’s no collateral.

Tom did a quick Google for student loan refinancing and found that the rates offered weren’t much better, with costs to refinance and higher monthly payments than he was comfortable with. He had the right idea, and for some refinancing can be a good move, but it didn’t yield quite the result Tom wanted.

Results

I pointed out one option to Tom he hadn’t found on his own, Splash1, started by my friend that allowed Tom to cut his interest rate in half. We estimated that Tom will save over $11,000 (in interest) by reducing his interest rate, a difference which can go toward anything he wants: Investing, saving, starting a company, or even just paying off other debt like a car loan. The point is, he did some homework, asked for help, and improved his situation.

Increasing your net worth, and you potential to get rich, is the result of making this sort of decision over and over. It’s not sexy or necessarily fun, but it does take away a lot of stress (Tom said this was the second biggest benefit) and sets you up for the next move. These moves build on each other. It’s simple, but that doesn’t mean it’s easy.

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