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Options for Paying Down Debt During Grad School

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A version of this post was originally published on GradHacker.

During my presentations on personal finance for grad students, I am frequently asked about debt – more specifically, when and how to pay off debt. Debt often appears to be an attractive option for low-income individuals like graduate students because it can enable you to “buy now, pay later” – acquire possessions or experiences now and spread paying for them out over months or years into the future. However, debt is even more of a trap for low-income people than it is for those with higher incomes because a greater percentage of your pay or cash flow going forward is going to be tied up in debt payments. This leaves even less flexibility in how the person uses his money than he would have without the debt.

Many if not most graduate students are in one or more kinds of debt, be it student loans (from undergrad and/or grad school), an auto loan, credit card debt, a mortgage, personal loans, etc. How a graduate student should manage her debt depends on her ability to repay the debt, her personal disposition toward debt, and the type and terms of the debt. Students who are able to pay down debt during grad school must choose their repayment method and balance that goal with other financial priorities.

debt repayment grad school

Ability to Repay

As a graduate student, what is your current ability to repay debt?

If you are taking on student loan debt during graduate school to pay for your tuition and fees or living expenses, any debt repayment you make is essentially trading your existing debt for student loan debt. While using student loan money to repay other debt might be attractive based on the interest rates, keep in mind that student loans, unlike all other debt, are virtually never discharged in bankruptcy. However, if you are struggling to make ends meet, in terms of taking on new debt, student loans are often preferable to high-interest debt such as credit card debt.

However, if you receive a stipend and tuition waiver, you may have the ability to make your minimum debt payments as well as meet other financial goals, whether they are saving or accelerated debt repayment. Students who grasp the power of compound interest will be motivated to cut back on their spending somewhat to put money toward debt repayment or investing.

Disposition toward Debt

People’s attitudes toward debt vary widely. On one end of the spectrum, some people view debt as a useful tool to help you live a better life or build wealth. (These people might be proponents of the permanent income hypothesis and encourage grad students to calibrate their lifestyles toward their expected future income rather than their current income.) On the other end, some people view debt as a dangerous burden that should be repaid as quickly as humanly possible. While you likely fall somewhere between those two extremes, it is important to reflect on how your debt makes you feel.

People who are quite bothered by their debt are likely to prioritize debt repayment over other financial goals. People who are less sensitive to the risk that comes with debt may use a more mathematical analysis to determine financial priorities, perhaps by paying down only high-interest debt before starting to invest for the long term. Any of those decisions are legitimate if they are congruent with the individual’s disposition and the ‘math’ of the situation (the terms of the debt) has also been taken into consideration.

Types and Terms of Debt

While it’s difficult to define any particular type of debt as “good” or “bad,” the terms of your debt should certainly influence how high of a priority accelerated repayment is. The chief term to pay attention to is the interest rate. What you used the debt for should also influence your repayment priorities. In some cases, you have an appreciating asset that collateralizes the debt, such as a home (in most cases), but other debt may have a depreciating asset as collateral, such as a car, or be uncollateralized. The dangerous aspect of uncollateralized debt or debt on a depreciating asset is that you don’t have associated property to sell to completely pay off the debt if it becomes necessary.

Student Loan Debt

Federal student loan debt and often private student loan debt is a unique type of debt because your student status and income can influence the repayment terms. While you are a half-time or more graduate student, you may be eligible for loan deferment, which means that no payments will be due. If your loans are subsidized, no interest will accrue during deferment. If your loans are unsubsidized, interest will accrue during deferment, and the interest will capitalize at the end of the deferment period and become part of the principal.

Deferment is a good option for graduate students because it gives the payer more flexibility to skip or shift around the now-optional payments if it is inconvenient to make them. Students could even save up for long periods and pay down the debt in lump sums. All students should make a plan for loan repayment during and/or following grad school, even those who cannot make progress until deferment ends.

Mortgage Debt

Graduate students who have taken out mortgages on their homes during and since the Great Recession likely have quite a low interest rate on their mortgage debt. The long-term average rate of inflation in the US is between 3 and 4%, which is similar to recent mortgage rates for top borrowers. After you reach 20% equity in your home and stop paying Private Mortgage Insurance, there is not much of a mathematical argument for making more than the minimum payments on the mortgage.

Consumer and Personal Debt

The terms for consumer debt can vary widely. In the current low interest rate environment, it’s not uncommon to have consumer debt at or close to 0%, but it can also easily be at 15-30%. How you prioritize paying off consumer debt may have a lot to do with the interest rate and other terms. Some debt offers come with a no payment or zero interest period of one or more years, sometimes contingent on the debt being paid off in full during that time. The repayment terms for consumer debt sometimes come with catches, so you should carefully abide by them or risk paying large sums of money in interest or hurting your credit score. Debts that are held by a family member or friend may have more favorable terms, but your relationship will be colored by the debt until it is repaid.

While it can be argued that student loans and mortgage debt have been used to buy appreciating assets, consumer and personal debt usually doesn’t have the same positive associations. For this reason, students may choose to prioritize repaying this debt just to get it out of their lives.

Paying Off Multiple Debts Simultaneously

If you have two or more debts that are immediate-priority payoff goals, there are two popular methods for choosing how to prioritize them: the debt snowball and the debt avalanche methods. Both methods work off the principle of intense focus on only one debt at a time.

With each method, you make the minimum payments on all your debts and throw all your excess cash flow at your top priority debt until you completely knock it out. With the debt snowball method, you rank your debts from lowest payoff balance to highest payoff balance and work on the smallest debt first. With the debt avalanche method, you rank your debt from the highest interest rate to the lowest interest rate and work on the most expensive debt first.

While mathematically the debt avalanche method is supposed to get you out of debt sooner (given the same amount of money contributed under each method), empirically the debt snowball method has been shown to get people out of debt sooner because of the psychological motivation garnered from the early win of paying off one debt completely.

Prioritizing Debt Repayment against Other Financial Goals

You likely recognize that there are financial goals other than just paying down debt that you might set during grad school, such as saving a cash emergency fund, saving for short-or mid-term purchases, and investing for the long term. Only you will be able to determine how those goals rank in comparison with accelerated debt repayment, after considering your personal disposition and the math involved with each scenario.

What is your experience with debt repayment during grad school? Which decisions regarding your debt are you happy with, and which decisions do you regret?

Why Pay Down Your Student Loans in Grad School?

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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.

What Is the Best Way to Pay Down Debt?

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The fastest way to get out of debt is energetically. If you want to get out of debt ahead of the schedule the minimum payments have you on, you must put forth effort and discipline both to free up cash flow by earning more or spending less and actually applying that cash flow to your debt in the form of additional payments.

One Debt

If you have only one debt or one type of debt and it’s going to be a long payoff process, you are going to have to find ways to keep yourself psychologically motivated through the process. You can do this by creating a visual representation of your progress, celebrating debt repayment milestones, treating yourself occasionally, reporting your progress to other people, etc.

Further reading: How to Get (and Stay) Motivated for Long-Term Debt Repayment, How to Stay Motivated While You Pay Off Debt

Multiple Debts

If you have multiple debts or multiple types of debt, there are two popular math-based methods for prioritizing your debt payoff journey, and one other practical option. In any case, it is considered psychologically beneficial to focus your energy on only one debt at a time. Make the minimum payments on all your debts, but channel your extra payoff money to just one until it is completely paid off.

The question is how decide in what order you should pay off your debt.

The Debt Snowball

The debt snowball method’s main champion is Dave Ramsey, a get-out-of-debt guru practicing today. In this method, you prioritize your debts by the payoff balance, smallest to largest, irrespective of the interest rates. The idea is that by getting an early win of paying off one debt completely, your motivation will grow and you will process through your list of debts at an ever-increasing rate. By the time you get to the debt that you expected to take you the longest to pay off, you have many smaller wins behind you to give you confidence to see the process through. Empirically, it has been shown that people who employ the debt snowball method get out of debt the fastest (psychology wins over math).

Further reading: ‘Snowball’ Debt Method Is Fastest Way To Pay Off Your Bills, Research Shows

The Debt Avalanche

In the debt avalanche method, you prioritize your payoff list by interest rate, highest to lowest. This method is the most mathematically optimal way to approach your debt payoff. If you devote the same amount of payoff money into the debt snowball method and the debt avalanche method, you will get out of debt faster with the debt avalanche method. Some people can become very motivated by interest rate math, and these people are especially suited to start their debt payoff journey well with the avalanche method.

Further reading: The Correct Way to Pay Off Personal Debt: The Debt Avalanche

What Bothers You the Most?

The debt snowball and debt avalanche methods both try to argue that there is one best way for everyone to approach paying off debt. But you know you best. If the goal is to pay off debt quickly and with great energy, you should ask yourself which debt bothers you the most or which one you are most excited to eliminate. Perhaps the answer will be the debt with the smallest payoff balance or the debt with the highest interest rate. Perhaps the answer will be the debt associated with the collector who is calling you multiple times per day or the debt you are most embarrassed to have taken out. Use what you know about your own individual psychology to start your debt payoff process off well and use that motivation to carry yourself through your list. It’s also perfectly fine to switch focus once you are left with only low-priority debt, if saving or other financial goals are more pressing than your remaining debt.

What Should I Do about My Existing Debt?

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If you have debt from the past and are currently living within your means, you have the option of doing more than making the minimum payments. How fast you want to get out of debt will depend both on the math of your situation and on your personal disposition toward debt and risk.

While you are a graduate student, you have the option of deferring your student loans, but the analysis laid out below will still be helpful in deciding whether to pay down those loans while you are in graduate school or to wait until after graduation.

Math and Facts

When deciding how quickly to get out of debt (or when evaluating new debt), the math of the situation should be given considerable weight. The most important factor is the interest rate on the debt. How does it compare to the long-term average rate of inflation? If you are considering paying down debt vs. investing, how does it compare to the long-term average rate of return you expect on your investments? How much interest are you paying on a yearly, monthly, or daily basis on your current debt balance? The higher the interest rate, the more weighty the argument that you should aggressively pay off that debt.

In addition to the interest rate, there are other attributes of your debt that should influence how quickly you pay it off (arguments for slower appear on the left, faster on the right):

  • fixed vs. variable interest rates – interest rates are set to rise at any time, so the low current variable rates are unlikely to stay low forever
  • low vs. high fees and penalties (pre-payment, late payment)
  • flexible vs. inflexible repayment options
  • secured vs. unsecured – this means whether the debt has collateral backing it, such as property, or whether it has no collateral tied to it, such as credit cards and student loans
  • bankruptable vs. non-bankruptable – student loans can virtually never be discharged in bankruptcy

Personal Disposition

Math alone is unlikely to hold 100% sway over your decisions regarding your debt, especially because risk is difficult to quantify. Your disposition toward debt matters greatly as well. There are some financial gurus today who will tell you that any debt you have is an emergency and you should pay it off as fast as possible. There are other financial gurus who won’t get fussed about you keeping low-interest debt while aggressively saving and investing. You have to determine where you fall with regard to your personal disposition toward debt, independent of the math of the situation. Does having debt give you anxiety? Are you more excited about meeting other financial goals while making minimum payments on debt? The only disposition that is really dangerous for your finances is an apathetic one in which you devote no energy to increasing your net worth; in that case, your debt is likely to become expensive.

Further reading: News Flash: Your Debt Is an Emergency, 11 Great Reasons to Carry a Big, Long Mortgage

What you bought with the debt may also play a role in how quickly you want to pay it off. If the debt was for a long-term appreciating asset such as a home or an education, you may be less inclined to pay it off quickly. However, consumer debt such as for cars or shopping (and sometimes student loans), which is debt that enabled you to live beyond your means for a time, is a type of debt that you may want to quickly put behind you.

In the end, the decision of how quickly to get out of debt is up to you, and it will depend both upon the math of your situation and how you feel towards debt. These factors also play important roles in your choice of which debt repayment method to use. As a graduate student, you likely don’t have a lot of disposable income to put toward debt repayment even if you want to. But wherever you start today, if you choose to be energetic about paying off your debt, you can find ways to increase the money you have available to pay down debt by implementing frugal practices or increasing your income.

Further reading: The Goal: Defeating Student Loan Debt

Credit Cards

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Depending on who you ask, credit cards are either dangerous or lucrative, a great convenience or a terrible temptation. What they really are, at their core, is a debt product. The credit card issuer has extended you a line of revolving credit in the amount of the card’s limit.

Further reading: Don’t Buy the Pro- or Anti-Credit Card Hype

When you make a purchase using a debit card, the funds are immediately or within a few days transferred out of your account to pay for the purchase. When you make a purchase on a credit card, you are incurring debt to the credit card issuer. Between the time you make the purchase and when the payment is due, the credit card issuer is giving you an interest-free loan. If you fail to pay the balance in full by the payment due date, the credit card’s interest rate then applies to the balance.

Credit cards can be very dangerous products, especially for those who live paycheck-to-paycheck, are inexperienced with money and banking, or are unorganized. This is because credit cards typically have a very high interest rate (the average rate is 15%), meaning that if you carry a balance on your card beyond the grace period that debt will become very expensive. (In today’s low interest rate environment, it’s difficult to think of any other debt product aside from payday loans that typically has interest rates higher than those on credit cards.)

However, when used with discipline, credit cards can confer some benefits, such as fraud protection, additional insurance, and rewards (in the form of cash back, airline miles, goods, etc.). The exact benefits the user gains from using a credit card can be learned from the terms and conditions. The terms and conditions will also detail how expensive a mistake can be in terms of the late fees and interest rates.

You must determine for yourself if credit cards are a useful product for you. Credit card companies make money not only from charging interest and late fees, but also from merchants. There is a percentage fee that credit card companies collect from every transaction, so you need to realize that their rewards structures and so forth are set up to induce you to spend more than you intended to. Credit cards can also be very tempting for people who don’t have any cash reserves in the case of an emergency or a month that is more expensive than anticipated, but these people are highly susceptible to getting stuck in a debt cycle with credit card balances that they have difficulty paying down. It may be better to avoid using credit cards entirely, because their very convenience ends up being a trap.

Further reading: “I Want a Credit Card, but I’m Scared”

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Perfect use of a credit card, or it never costing you more than cash would, entails always paying the balance off in full on or before the due date and never spending more than you would if you were using debit or cash.

One of the most important attributes of credit card usage to be cautious about is its ability to dissociate the act of making a purchase from the consequence of paying for it. Even if you pay off the balance in full every period, it is possible to get 1-2 months behind in your spending in comparison to if you used debit or cash because of the grace period credit cards give you. Even if you never actually pay fees or interest, this is an undesirable position to be in because you are borrowing from your future paychecks when you make a purchase.

Further reading: Living on Time with Your Credit Cards; Credit Cards Are a Necessity, If You Are Responsible