By David Klein, CommonBond
"So what does the stock market dropping 500 points in a week have to do with my student loans?" That's a question I got a few days ago. And the answer may interest you, if you have student loans.
"A random walk down Wall Street"
The stock market is a tricky and fickle thing, or so it sometimes seems.
If the stock market trends downward for a while, it could be a reflection of the broader economy suffering (e.g., consumers aren't spending as much, which puts downward pressure on corporate profits and therefore on company stock prices, too). In that case, it's the job of the Federal Reserve (the "Fed") to help nurse the market back to health. One of the main ways it does that is by decreasing interest rates (specifically, decreasing the interest rate that banks are charged for acquiring money), which decreases the "cost" of money - i.e., interest rates on loans - for consumers.
But it could also mean something else - as it did recently when the stock market sunk about 500 points in 5 days. In that case, the market dropped because of its expectation that the Fed would raise rates. The notion being that if/when the Fed raises rates, economic activity might slow, which would put downward pressure on stock prices (or on the acceleration of stock prices). Investors wanted to get out in front of that potential eventuality by selling their stock before the reality actually hit.
So how do you know when a stock market dip signals a likely increase or likely decrease in broader market rates? Well, a good place to start is to understand whether the Fed gave the signal to the stock market, or the stock market gave the signal to the Fed. Here’s what I mean: If a stock market dip is a reaction to the Fed, then it might mean that the Fed signaled that it would raise interest rates (as we saw last week). But if a stock market dip is instead a signal to the Fed, then it might mean that the broader market is struggling, which in turn leads the Fed to decrease interest rates to spur economic activity (as we saw leading into and through the Financial Crisis).
So what does this have to do with student loans? Well, a lot actually.
Fixed v. Variable rate student loan: Which should you choose?
If you believe the Fed will not raise interest rates for a while - or will not raise interest rates too much by the time you pay off your student loan - then a variable rate loan could be the best option for you. It would be the loan for which you pay less in interest over your repayment period, relative to a fixed rate loan, which is set at a higher level than a variable rate loan at the start of the loan term.
Variable rate loans have lower interest rates than fixed rate loans because variable rates move up and down with the market, while fixed rates stay fixed at one level regardless of how market rates move. With variable rates, you’re “taking a chance” on the future direction of market rates. You’re “rolling the dice.”
Because you're rolling the dice - or rather, because you don't have certainty over where rates will go, yet you're still willing to go with that option - you get to pay less in interest at the start of the loan. You're essentially getting "compensated" - near term - to take that risk. But that "compensation" in the near term could turn into a "cost" in the long-term if market rates increase more than you expected during your prepayment period, meaning the amount you pay in interest over time could be more with your variable rate, because the fixed rate locked in one constant rate, while the variable rate kept rising (with market rates) past the fixed interest rate.
People generally choose fixed rate loans when they don't want to deal with the uncertainty around whether market rates will rise and fall over time. People who want to "play it safe" choose this option - if market rates shoot up, then the fixed rate loans will have been the "right" loan, but if market rates stay the same, or decrease, then the variable rate loan would have been the "cheaper" loan over the life of the loan.... The person who goes for the fixed rate is basically saying they want to protect themselves against the possibility of market rates shooting up, so they lock in one rate, which will not change over the life of their loan.
So in determining whether you want a variable rate loan or a fixed rate loan, it very well could come down to which phrase better describes you: “Roll the dice” or “Play it safe.” If you’re a “roll the dice” kind of a person, then variable rate could be for you. If you’re a ‘play it safe’ kind of person, then fixed rate could be for you. For more detailed analysis on the question of "fixed vs. variable," read my co-founder’s post on the topic here.
Prepaying your student loans: Should you do it?
All said, if you believe the stock market will be trending upwards for a while, then it very well could influence your decision to prepay your student loans as quickly as possible vs. paying down your student loans more slowly and in accordance with your monthly payment plan.
If you're in a position to prepay your loans - that is, pay more than your monthly payment (so that your excess payment goes toward paying down your loan principal) - then you might want to invest your excess money instead of prepaying your student loan. It all depends on (a) what your student loan interest rate is and (b) what return you think you'd get if you invested in, say, the stock market. For example, if (a) your student loans' fixed interest rate is 4.74% for 10 years and (b) you believe the stock market will fetch you a 7% annual return for 10 years, then you should invest your excess capital in the stock market so that it earns 7%, instead of using your excess capital to pre-pay your student loan, which would only save you 4.74%.
It's a simple equation, and one you should keep in mind as it relates to personal finances. But it's also a difficult question to know the "right" answer to. How do you "know" that the stock market will yield a better return than what your student loan interest rate is? You don't. But you can make an educated determination of how you might tie out after, say, a 10-year period, by doing your research and using your own risk tolerance as a guide.
David Klein is CEO & Co-Founder of CommonBond, a student lending platform that provides a better student loan experience through lower rates, exceptional customer service, and a commitment to community. CommonBond is also the first company to bring the 1-for-1 model to education and finance. Prior to CommonBond, David worked in consumer finance at American Express and advised clients in the financial services industry at McKinsey. David attended business school at the Wharton School.