By Michael Taormina, CommonBond
I recently laid out some key considerations for thinking through a fixed rate vs. a variable rate student loan option ("Is a variable rate loan right for me?"). Ultimately, a borrower's unique individual circumstances, in light of those considerations, determine which option makes more sense. The same is true for choosing a repayment term length, and this post asks five key questions to help a borrower arrive at the best repayment term for his or her specific financial situation.
1) First, why does the length of the loan repayment term even matter?
If you're like me, you want to pay off your student debt as quickly as humanly possible -- while also prudently taking into account any other competing financial goals (retirement, vacations, buying a house, etc.) as well as the level of disposable income and savings you have on hand to pay your debt off.
Your loan's repayment term affects these competing interests because it directly impacts the size of your monthly scheduled loan payment -- the amount of cash you need to set aside each month to stay current on your loan. For example, let's assume you are looking to refinance $100,000 in student loans and are weighing three different repayment term options. (I use $100,000 both for "easy numbers" and because there are a good number of students graduating with this much debt!) For simplicity's sake, we'll keep the interest rate the same across all options to isolate the effect of extending the loan repayment term.
Here is what your monthly payment will look like for a loan with a 5-, 10-, and 15-year repayment term, respectively:
Monthly Loan Payment for Different Repayment Terms
*assumes uniform interest rate
Bottom line: the choice of repayment term directly impacts the amount of cash you'll need to set aside each month to make your monthly student loan payment and also determines how long you'll be paying back your student loans. A longer repayment period reduces your monthly loan payment, all else equal.
2) How does repayment term affect the interest rate you're charged?
The example above assumed the same interest rate for each repayment term, but in reality, the interest rate will be different for each repayment option. If you want to borrow money for a longer period of time, all else equal, the interest rate will typically be higher to compensate the lender for the added uncertainty from providing funds for a longer period of time.
So let's incorporate that reality into the example by simply assuming a 5 percent fixed rate for a 5-year and a 7 percent fixed rate for a 15-year loan:
The Effect of Higher Interest Rates
Bottom line: a longer repayment term reduces a borrower's monthly loan payment, but that benefit comes at the cost of a higher interest rate.
3) What are other tradeoffs to consider in choosing a repayment term?
On the face of it, the 15-year term appears to be the clear winner. You pay the least per month, and therefore free up cash for other expenses and financial goals. However, while that's true, the payment is only lower because you are repaying less principal today... and delaying the repayment of that principal into the future.
In other words, there's no free lunch won by extending your term. You haven't saved any interest by choosing a 15-year repayment term. Rather, by kicking the proverbial loan repayment can down the road, you have instead increased the total interest that will be paid over the life of your loan because the loan will accrue interest for a longer period of time:
Total Interest Paid for Different Repayment Terms
Bottom line: when choosing a repayment term, there is a natural trade-off between minimizing your monthly loan payment vs. minimizing total interest paid over the life of the loan.
4) How do prepayments affect the repayment term decision?
Our examples have assumed zero prepayments made during the entire repayment period. "Prepayments" are payments made in excess of the scheduled monthly loan payment. For example, if a borrower refinances $100,000 of student loans with the hypothetical 10-year loan option, the resulting payment would be $1,110.21 each month. If instead the borrower pays $1,500 for his or her first monthly payment, the extra $389.79 would go towards paying down the outstanding principal balance. By reducing the outstanding principal, prepayments work to shorten the repayment term of the loan. For example, if the borrower pays an extra $300 per month, he or she will pay off the 10-year loan in less than 7.5 years.
Some borrowers make only the scheduled monthly payment, but in our experience, most borrowers do prepay a portion of their loans along the way. Bonuses, savings and increased salary are typical reasons behind a prepayment. (For one grad's perspective on how much he has decided to prepay, check out this piece by our own Nate Howard.) Most lenders -- CommonBond included -- do not charge a prepayment penalty, but it's still important to review the lender's repayment policy for any qualifiers that could reduce the attractiveness of prepaying.
Prepayments can significantly reduce the total interest paid over the repayment period, without impacting the monthly loan payment. For example, let's assume you make only the scheduled payments -- i.e., no prepayments -- for the first 5 years of the repayment term, and then you make one large prepayment in the 60th month to fully pay off the remaining loan balance.
The Effect of a Single Prepayment on Total Interest Paid
That single prepayment greatly reduces the cost (interest paid) for choosing either of the longer repayment terms. Note that you would still pay more interest over the 5-year period if you had chosen a 10- or 15-year term, but much less interest than if no prepayment was made along the way. That extra interest is the effective cost for the borrower's option to flexibly prepay at his or her convenience.
This is a critical point. While a 5-year repayment plan minimizes total interest paid, it also binds the borrower to pay $1,887.12 every single month. That may provide little room for error based on the borrower's monthly income, both to meet other expenses and to build a savings cushion in the event there is a financial hiccup along the way.
If a borrower instead wants the option to pay less each month, they can take that option by choosing a loan with a longer term, but the price they pay for that option is higher interest paid over the life of the loan thanks to 1) a higher interest rate for a longer loan term and 2) the delay in principal payments, which keeps your outstanding loan balance larger for longer.
Bottom line: Prepayments reduce both the total interest paid and the life of your loan. If your goal is to pay off your student loans as quickly as possible -- but only to do so when you are in a financially comfortable position -- a longer repayment term may be worth the cost of paying extra interest until you can prepay the remaining loan balance.
5) How does your specific financial situation affect your repayment plan choice?
The considerations thus far are applicable to all borrowers, but your specific financial situation will determine which repayment option makes the most sense for you. The calculus behind making the right choice for your specific situation starts with calculating how much disposable income you have after first taking into account absolute life essentials (rent, taxes, food, insurance, health, etc.) and then taking into account an estimate for other things on which you'd like to spend the remaining income (vacations, gifts, investments, etc.). The difference between these two figures -- your essential spend and your discretionary spend -- is an estimate for how much income you will have available for your student loan payments. I recommend adding an expense cushion of 5 percent of your post-tax income for emergencies or underestimations, just in case.
Using our three hypothetical refinance options as an example, if you were capable of making a $1,400 student loan payment each month, the 5-year term option is probably not your best move, and you may look to either the 10-year or 15-year options to take advantage of the lower monthly payments.
Bottom line: Your personal financial goals have great influence over your repayment plan choice. If your financial situation improves over time, you may be in a more comfortable position to make prepayments to eliminate your remaining student debt.
Note: All charts contained herein are for illustrative purposes only.
About the author: Michael Taormina is the CFO of CommonBond, a venture backed financial services company that has raised over $100M to lower the cost of student loans in the U.S. In his role at CommonBond, Mike focuses on financial planning and analysis, budgeting, accounting, pricing and capital strategy.
Prior to CommonBond, Mike was a Vice President at J.P. Morgan Asset Management, where he specialized in interest rate and foreign exchange trading for high-net-worth clients. He worked directly under the CIO of J.P. Morgan Private Bank, constructing the core investment strategy for over $300B in private client assets. Formerly, Mike also served as the President of the JDRF Young Leadership Committee of NYC, a volunteer organization that raises funds for Type I diabetes research, and was Co-Founder & President of the Philadelphia chapter while earning his MBA.
Mike graduated summa cum laude from Georgetown University with a BS/BA in Finance & International Business and from the General Course at the London School of Economics. He attended the Wharton School and is a CFA Charterholder.