Karen Wons of Maryland finds herself in a quandary that is confronting many parents right now.
She is struggling with how best to advise her daughter - a recent college graduate - on paying down her $25,000 in student loans.
Wons did what any wise parent would do. She asked for help.
Here's the back story. Wons' daughter works as a project manager at a medical software company. She has an annual salary of more than $50,000. Her employer provides a 401(k). She has about $13,000 in cash from recently redeemed Series EE savings bonds. She has no credit card debt. She has no payments on a reliable car with low mileage. She's sharing an apartment and other living expenses with an older sister in Madison, Wis. Her portion of the rent is just over $500 a month.
Wons is unsure about the course her daughter should take with her debt. She asked the following:
¢ Should the daughter consolidate her college loans during her six-month grace period? (She has federally backed Stafford and Perkins loans.)
¢ Should she use the entire $13,000 to pay down the loans or keep making monthly payments to take advantage of the interest deduction?
¢ Should she invest all of the $13,000?
¢ While paying off the loans, should she contribute to her 401(k)?
Let's take the consolidation question first. Mark Kantrowitz, publisher of www.finaid.org, one of the best student loan informational Web sites available, recommends that Wons' daughter consolidate any Stafford loans that were disbursed before July 1, 2006. Graduates who consolidate their Stafford federal student loans during their grace period - the six months after graduation - are eligible for a 0.6 percent interest-rate reduction. If she consolidated the pre-2006 loans, her rate would be 6.625 percent compared with 7.22 percent at the end of her grace period.
Stafford loans disbursed after July 1, 2006, are fixed at 6.8 percent, so there is no need to consolidate them, he said. When you consolidate Perkins loans, you lose favorable repayment benefits such as loan forgiveness and a nine-month grace period, as well as subsidized interest during any periods of deferment. The 5 percent rate for Perkins loans is fixed, so there's no advantage to consolidate them with other loans, Kantrowitz said.
Under the federal consolidation program, student and parent borrowers can bundle all of their loans into one fixed-rate loan and stretch out the payments to 30 years from the standard 10 years, depending on the debt amount. Stretching out the loan means a lower monthly payment. It also means increasing the cost of the loan.
I agree that Wons' daughter should resist the temptation to stretch out the payments. Her expenses are low now, so why not pay off the loans? Besides, people say they'll make extra payments, but it's a promise that is easily and often broken because it's hard to maintain the discipline to retire debt early.
With regard to paying down the loans versus investing the $13,000, it's a matter of comparing the after-tax impact of the two options, Kantrowitz said.
That comparison would include the fact that some borrowers can deduct up to $2,500 of student loan interest.
However, if you're single and your modified adjusted gross income is between $50,000 and $65,000, the interest deduction is gradually reduced, as it would be for Wons' daughter. Once her MAGI is $65,000 or more and if she's still single, she gets no deduction.
I know conventional wisdom says that if the projected after-tax gain on the $13,000 investment is higher than the interest she would pay on the loans, taking into account the tax break, she shouldn't worry about paying down the debt. But an investment return isn't guaranteed. Investing involves risk. There's also the possibility she'll be tempted to spend the $13,000 and any gains.
If it were my daughter, I would tell her to pay down the debt, holding back three months' worth of living expenses. For Wons' daughter, that might come to about $4,500, which she should park in a high-yielding savings account or money market.
The remaining $8,500 should go to pay off as much of the Stafford loans as possible.
Pay the Staffords first because they carry a higher interest rate than the Perkins loans.
And, yes - even while paying down debt - the daughter should contribute to the 401(k), especially if her employer offers to match a percentage of her contributions.