So How Much Debt CAN You Afford?
People take on exorbitant amounts of debt in the name of getting a good education. I’ve met people with a general BA who have $40,000 in debt. I’ve met people with a Master degree with $60,000 and I’ve met people with big-ass degrees carrying $150,000 in student loans.
Here’s the thing: If you know you’re taking on debt that you’re going to be able to repay, then fine. But if you’re taking on whopping debt that will affect your ability to have a LIFE once you’re done with school, you have to ask yourself if it’s worth it.
If you’re planning to get a car loan, lenders will apply some basic rules about how much you qualify to borrow. If you’re planning to buy a home, you have to qualify based on your income. But when you take on student debt, no one asks you to think about how much you’re going to have to repay when the time comes.
Figuring out how much you’ll have to repay isn’t hard. It’s a matter of knowing your interest rate, and how long you want to take to pay off the loan. I’m going to show you the mechanics of it first, because everyone should understand them.
Let’s say, for example, that you have a $20,000 loan at 8%, and you want to have your student loan paid off in 3 years, which is 36 months.
First, the interest: $20,000 x 8% ÷ 12 (months) = $133,33. That’s the interest part of your monthly payment.
Now the principal repayment: Take your total principal of $20,000 and divide it by the number of months you want to take to pay off the loan, in this case 36.
So, $20,000 ÷ 36 = $555.55.
Add the principal amount of $555.55 to $133.33 in interest and your monthly payment is $688.88.
That’s a good indicator of what your monthly payment will be on the loan. It’ll actually be a little less since interest is calculated on a declining balance (as you pay off your loan, the principal goes down, so the amount of interest goes down).
The government of Canada has a website that offers a loan repayment calculator (http://tools.canlearn.ca/cslgs-scpse/cln-cln/40/crp-lrc/af.nlindex-eng.do) to take the math out of the exercise, if you’re number-challenged. You can enter up to three scenarios at a time to see how much you’ll have to pay monthly along with the interest you’ll pay over the life of your student loan.
Some important things to note about student loans. First off, you can choose a fixed or floating rate of interest on your loan.
If you choose a fixed rate, you’re choosing a stable rate of interest that you will be charged throughout your repayment period. The Loan Repayment Calculator uses a fixed rate of prime + 5%. So if the prime rate is 4.5%, your rate for a fixed loan would be 9.5% (4.5% + 5% = 9.5%).
Your alternative is a floating rate that varies over time with the prime rate. If you negotiate a floating rate, your percentage will increase and decrease along with the prime rate. The Loan Repayment Calculator uses a floating rate of prime + 2.5% so if the prime rate is 4.5%, your interest rate will be 7% (4.5% + 2.5% = 7%).
Why is there a premium if you choose a fixed-rate loan? That’s to cover the lender’s butt should rates rise significantly. Since your rate is fixed, they can’t ask you for more money. The upside to paying a higher interest rate up front is that you know exactly how much your payments will be and when your loan will be paid off.
If you choose a variable rate of interest, and interest rates fall, you’ll pay even less. But if rates rise, you’ll pay more. And, sadly, most people don’t understand the implication of this. The Student Loan folks don’t actually raise your payment amounts (unless you aren’t even covering their interest.) What they do, instead, is put more of your monthly payment toward interest, and less toward principal. I’ve worked with people who have two years of student loan repayment had paid off a whopping 17¢! No kidding.
If you choose a variable rate of interest, you have to be prepared to watch the interest rate market and make adjustments when rates rise. You could:
- Lock into a fixed-rate loan at that point, or
- Increase your monthly payment so you’re still paying off the principal.
Just as important as understanding how interest rates work is understanding the total cost of your loan depending on how long it takes you to repay what you owe. The student loan system default repayment term is 114 months, which is 9.5 YEARS.
Why do people go with the default 114 months? Easy. It makes the payments more manageable. A $20,000 loan fixed for three years has a monthly payment amount of $643. Over five years (60 months) the payment drops to just over $422 a month. Over 9.5 years? Just under $270 a month. So, if you’re just graduating from school, what would you choose? Most people go with the longer-term loan and the lower payment, without giving a second’s consideration to the cost of the loan. That three-year loan will cost $3,148 in interest. The five year loan? $5,349. The 9.5 year loan? $10,748! On a $20,000 loan you’ll pay more than 50% more in interest. OUCH!
Okay, so let’s talk about payments relative to income for a minute.
Let’s say you’re earning $10 an hour, working a 35-hour week. You’re Grossing about $18K a year, or netting about $14K or $1200 a month. If you have to make a loan payment of $643, you’d be choking on your debt since it would be eating up more than half your net income. Assuming you have any living expenses, that amount of debt repayment may seem completely unmanageable.
This is particularly true if you’re getting married, setting up a home, buying a car, going on vacations, or any of the other wonderful things you may want to do with your life. And since the rule of thumb is spend no more than 15% of your net income on debt repayment, you’d have only about $180 a month to repay that student debt, which means it would take FOREVER to get out from under.
Hey, who says you have to settle for that. You can do one of two things:
- Increase how much you make per hour, or
- Increase the number of hours you work.
This is the part that separates the KIDS from the ADULTS. KIDS want to continue to live in La-La-Land, having whatever they want, whenever they want, not thinking of the future, eating out, going to partays, buying stuff. ADULTS know that if they are ever going to have a life, they have to get rid of the debt. That means doing whatever it takes to get that monkey off their back.
But that means going into the whole proposition of post-secondary education with a plan. You need to have anticipated:
- what your income was going to be,
- where you’d be living and the expenses associated with keeping a roof over your head and food in your belly, and
- how much debt you would be able to repay in a reasonable (five years or less) amount of time.
If you know you’re going to be making $75,000 a year in your chosen field, you know you can afford to take on more student debt than if you’re only making $20K. And since the person making $20K is spending a much larger percentage of income on keeping body and soul together, they can ill afford to also have a ton of debt to deal with.
So what’s the alternative to debt? Good question. That’s the next article. Read on.