Getting a handle on student loans
If you’ve just finished college and are heading to a new job, avoid the extremes. In other words, don’t panic about your student loans, but don’t ignore them either before locking yourself into huge expenses like rent and car payments.
With so much attention on student loans in the news, college students tend to get alarmed when financial aid offices force them to look at their loan responsibilities just as they leave the hallowed halls. The typical student with loans leaves college with $35,000 in debts.
But rather than worrying about loans, many graduates take the opposite approach, said Shannon Schuyler of professional services firm PricewaterhouseCoopers. Students leave college without thinking ahead, and they get themselves into a financial mess, according to research by George Washington University’s Global Financial Literacy Excellence Center that was funded by PwC.
That research shows most Millennials “don’t have basic knowledge” about handling money and consequently dig themselves into a hole shortly after finishing college, said Schuyler. About 28 percent of those with college degrees have ended up taking emergency payday loans or selling possessions to pawn shops, she said.
The size of student loans alone, however, is not necessarily the problem.
A rule of thumb for college loans is to keep the loan payments to 8 percent of your salary. So for $35,000 in loans at recent interest rates, a person would need an annual salary of about $53,250. But college finance expert Mark Kantrowitz, publisher of Cappex.com, said people should be OK if they simply make sure their total college loans don’t exceed their annual pay.
People with federal student loans have 10 years to pay them off, so payments on $35,000 in loans charging an average interest rate of 4.05 percent would be $355 a month.
If your first job pays too little to cover loan payments, you may qualify for a government program that reduces monthly payments while your income is low. It’s called “income-based repayment.”
And if you still don’t have a job when your loan payments start six months after graduating, you can ask for a deferment, which means you don’t have to pay your loans yet.
Keep in mind, however, that deferring your payments or reducing the monthly payments while your income is low doesn’t free you of the responsibility indefinitely. Eventually, you will have to pay both the interest and principal unless you can’t finish all the payments within 20 years.
Kantrowitz advises graduates to avoid extending loans beyond 10 years of repayments because extra years add a lot more interest. Even if you pay off $35,000 in loans in 10 years, you are going to be paying $7,622 in interest, or a total of $42,622 based on the $35,000 principal plus the interest payments. And if you pay off a $35,000 loan, with a 4.05 percent interest rate over 20 years, you will be spending $16,123 on interest, or $52,123 in total. Think of what $16,123 could buy if it wasn’t going toward interest. A car? The start of a house down payment?
“Always pay as much as you can each month” so you keep your interest charges as low as possible, Kantrowitz said.
To do that, think of the rest of your spending. Overspending on rent, a car, or anything else could disrupt your future.
Consider keeping within a 50-30-20 budget. Fifty percent of your income is devoted to necessities: housing (rent, utilities), food, transportation, required payments on student loans, credit cards or other loans, phone, internet, even gym payments if you sign a one-year contract. Thirty percent goes for entertainment and choices you could skip: clothing, restaurants, gifts, travel. Twenty percent goes toward saving. Saving for emergencies and retirement is essential.
An emergency fund will help if you lose your job or have expenses like flat tires. Without emergency funds, people tend to use credit cards, fail to pay them off each month, and get into a spiral of paying interest.
Saving for retirement on your first job is essential because your early life savings give you a huge head start. Assume you are 21, earning $35,000, and you put 7 percent of pay in your 401(k) at work, and your employer gives you 3 percent through a company match. That’s about $1,050 in free money. If you keep on saving like that until 65, you will have about $1.1 million for retirement if you earn 8 percent on average each year.
If instead you wait until you are earning $50,000 at age 35 to start saving the same percentage, you will accumulate only about $502,000.
What will that mean when you retire? With $1.1 million you will be able to spend $44,000 a year when you retire. With the $502,000, you will only be able to spend $20,080. If $20,080 looks OK, consider that there will be inflation and to buy what you do today with $20,080 you will need about $44,400 40 years from now.
Gail MarksJarvis is a personal finance columnist for the Chicago Tribune.