Why Pay Down Your Student Loans in Grad School?

While you’re in graduate school, you have the option of deferring payments on the student loans you have previously taken out. This is a very standard procedure that your lender should have no trouble helping you with once you make the request. Deferment means that you are not required to make payments on your student loans. You are allowed to defer student loans when you are enrolled at least half-time in graduate school.

That’s where many graduate students stop thinking about their student loans. “I don’t have to pay? Awesome!” But just because you defer your student loans does not mean that you should ignore them. Even in deferment, you have the option of making payments of any size you choose on your student loans. Depending on the rest of your financial landscape and the interest rate of the loans, it can be a good idea to pay down your loans while you are in graduate school.

When your student loans enter deferment, you don’t have to make payments but the loans still accrue interest at their given rate. In the case of federal subsidized student loans (which are now only available to undergraduates), the federal government pays the interest for you, so your loans don’t grow any larger. In the case of federal unsubsidized and private student loans, the accrued interest adds to your balance due. When your loans exit deferment, the interest capitalizes, which means it becomes part of the principal due, making your accruing interest and minimum payments even higher.

Interest rate is crucial

The higher the interest rate on your unsubsidized loans, the faster the loan balance will grow during the deferment period. Let’s look at a few examples. Direct unsubsidized loans for undergraduates are offered at 4.45% and direct unsubsidized loans for graduate students are offered at 6% (as of June 2017). Private student loans might be offered anywhere from 3 to 12%.

This table illustrates how much your loan balance would grow at the given interest rate if you made no payments (deferred) for five years.

You can see how much the interest rate itself affects the balance after five years. And remember, interest will continue to accumulate throughout the entire life of the loan! Not making payments just allows the problem to grow larger.

If your student loans are currently deferred, you have a decision to make: Should you make payments on your student loans even though you don’t have to, and what amount should you pay? There are different answers depending on your exact situation.

You can’t pay – period

Some graduate students have no choice here; they are simply unable to make any payments on their student loans. This might be because they are taking out more student loans or consumer debt during graduate school or because their stipend only just covers their bare-bones living expenses. This is a situation in which deferment is sorely needed. The best course forward is to finish graduate school in a timely manner, get a well-paying job, and start repayment when the deferment ends.

You might be able to pay, but you’re reluctant to free up the cash flow

Many graduate students who receive stipends technically have the ability to make payments toward their student loans if they want to, but they either don’t recognize their ability or are unmotivated to make the sacrifice to their lifestyles. When you’re not compelled to put money toward your future, it’s easy to let your lifestyle inflate to your income level.

When you’re dealing with compound interest, like with debt repayment or investing, the question comes down to how much you value an amount of money now vs. a larger amount later. How much larger an amount depends on the interest rate. Yes, it would be a sacrifice to cut $100/month from your budget, for example, to make a regular payment on your debt, and it would almost certainly be easier to sacrifice $100/month out of your larger post-grad school income. But remember that we’re not comparing $100 now to $100 later – more like $100 now with $120 or $140 or $160 later.

What the tipping point is between those two options is up to each individual to decide based on his risk tolerance, post-graduation income prospects, and lifestyle desires.

You have available cash flow, but you’re not sure if it should go toward the loans

Other graduate students have already identified some amount of cash flow each month that they want to put toward their financial goals, but they’re not sure if their loans should be their top priority. Maybe they feel they could also use some additional cash savings on hand or are excited about investing.

As long as the student has a satisfactory emergency fund and/or cash for short-term spending and no higher-interest rate debt, putting the cash flow toward either the debt repayment or long-term investing is a good choice. Which one comes out on top should be determined based on two primary factors: the math and your personal disposition.

The math: Compare the interest rate on your debt with the average annual rate of return you expect on your investments. If your interest rate is much lower than your expected average annual rate of return, that’s a big argument in favor of investing over debt repayment. If your interest rate is comparable to or higher than your expected average annual rate of return, that favors debt repayment.

Personal disposition: How you feel about this investing vs. debt repayment decision matters, too. If you can’t sleep at night for thinking about your looming debt, just work on paying it down. If the math doesn’t sway you strongly to one side and you are super excited about starting to invest, go ahead and do that (but keep in mind that losing money is a distinct possibility).

Remember that subsidized loans are effectively at a 0% interest rate, so repaying those loans would only be a top priority for someone who really hates their debt.

Payment strategies

If you have decided to repay your student loans to some degree during grad school, you have some options on how to do so.

The first is that deferral decision that we assumed at the beginning. Even if you don’t feel you have to defer because you can easily afford the minimum payment, deferring still may be advantageous for two reasons: 1) If something ever came up that prevented you from making your required payment, your credit score would take a hit. 2) With no minimum payment required across all your loans, you can choose to pay down one loan at a time.

Second, assuming your loans are deferred, you can make regular payments or save up for some time and make larger, lump-sum payments. It might be easier to make fewer payments over the course of a year, but if your loans are unsubsidized you would lose a little bit of money to interest accumulation. Talk with your lender to see how willing they are to accept payments of variable amount and at irregular times. For subsidized loans, you wouldn’t be penalized for building up your payoff money in your own coffers up through the entire deferment period as long as you paid the sum before the loans exit deferment.

Third, within your set of student loans, you may have multiple different interest rates, perhaps including both subsidized and unsubsidized loans. If you have decided to commit a certain amount of money to loan payment, you should put the whole payment toward the unsubsidized loan with the highest interest rate (the debt avalanche method).

Pay just the interest

One option that I haven’t yet mentioned is the common suggestion to pay off only the accruing interest during the deferment period so that the loan balance you have upon exiting deferment is exactly the same as the loan balance that you had upon entering deferment. While it is a fine idea to pay some amount toward the loans during deferment, I don’t see a compelling reason why that number should exactly equal the amount of interest accruing. If you have the ability to make interest-only payments, why stop there? You should pay as much as your budget allows.

I do think it’s a good idea to defer your student loans while you are in graduate school. And on top of that, to the greatest extent you are willing you should put your money toward increasing your net worth. Both debt repayment and investing fulfill that goal well, and which one you choose will depend primarily on the math and your personal disposition. The higher the interest rate on your student loan debt, the more compelling the argument for paying it down while you are in grad school.