One of the biggest challenges many borrowers face as they take on the challenge to pay off student debt is the problem of how to evaluate options, actions, decisions. Think about it for a second: there are so many variables when it comes to your student loans that your head probably swims just listing them all out:
- Your monthly payment
- Interest rate
- Term of the loan,or how many years you have to make payments
- Forgiveness options
- Variability or otherwise of the interest rate
- Tax implications if you receive any loan forgiveness
- The myriad repayment options on federal loans
How is it possible to compare so many options against so many different variables? And more importantly, how can you ever create and use a yardstick that works whether you’re thinking about just a plain vanilla loan refinance or a complex income-based repayment plan that makes your payments go up and down as your income likewise goes up and down?
You may be tempted to view the enormity of the challenge and to simply give up., hoping to trust to your gut and luck to make your decisions.
Believe it or not, there is a single number that can wring the complexity and information out of all these myriad variables and extract a single and highly useful number out of every one of them. With this number, you can more confidently, boldly, make the smartest decision you can on how to pay back your student loans.
The one number that keeps score
Before we get into what this number is, I’ll provide the standard warning here: while it is possible to make a very good guess on which way this number is heading with any of the options you consider, you will really reap the benefits of this number when you gird yourself up to face a little bit of math. But no worries, more on that later.
First, let’s head to the concrete canyons of Wall Street and figure out how these smart pundits of finance make their multi-billion dollar decisions on buying or selling stocks, companies, or even making investments in hot new startups.
Everyday these pundits make hundreds of thousands of decisions to buy and sell companies, invest in this IPO or that, buy or sell stocks, currencies and every other form of asset, all in apparently no time. And yet millions, maybe even billions of dollars are at stake. How do they do this?
The common factor underlying every one of these transactions (as well as your student loan payments), is that each one can be boiled down into a series of numbers – representing how much money changes hands, in which direction and at what time. For example, if you’re buying a company, you fork out a bunch of cash today, in the hope of getting steady cash flow from the shoes or clothes or other cool stuff this company sells to an adoring public, to recoup all this money you paid upfront.
Similarly, when you took out your student loans, you got a bunch of cash immediately (or over the course of your time in school) to allow you to make your tuition payments and meet living expenses. In exchange, you made a promise to make regular and specified payments over the course of many years to repay that obligation.
In either case, the person who forked out the cash initially (whether it was the buyer of the company, or the lender of your student loan), had to sacrifice opportunities to use that cash to earn money somewhere else. So the buyer of the company could have just invested in the stock market. Or the lender of your loans could have found some other borrower to lend to, or opportunity to invest in. We call the money they could have earned from this next option their “opportunity cost”.
But what is this magic number?
Yes, we’re coming to that.
Between this series of money changing hands over time, and the rate at which this cash would have earned the owner income, we have everything we need to boil all of these down into a single number.
That number goes by the yawn-inducing name of net present value (NPV), but contains within its concise and diminutive form the power to move mountains.
Briefly, what the NPV does, is to reduce all these different comings and goings of cash, subtracts out whatever income could have been earned at the time the cash exchanged hands, and boils all of these down into a single equivalent number in today’s dollars.
Here is a simple way to think about what NPV represents. Let’s say you have a big, fat student loan of $60,000 weighing on you right now. One day, on a whim, you decide to buy a lottery ticket, and bingo, you realize you won the jackpot! Being the smart person that you are, you decide that you no longer want to have any debt hanging over your head, and call all your lenders and offer them a single lump sum to extinguish all your future obligations on this debt.
The NPV is the number that a sane lender would ask for, because it should be a matter of indifference to them whether you paid that amount today, or continued to make loan payments according to your contract. They’d expect to be in the same exact financial position with either option.
In other words, the NPV is the translation of your student loan transaction, with all its vagaries in payments, and terms, into what a rational person would be happy to exchange that investment for, in hard cold cash today.
So if you’re the person forking out those student loan payments, your biggest objective should be to make that exchange value as small as possible. In other words, in this happy winning-the-jackpot scenario, you would naturally want to pick the option that made you fork out the least amount of money today in return for having all your future repayment obligations extinguished.
Voila! There you have your number.
The good news is that you can use this number even if you haven’t won the jackpot.
As long as you are picking the option that makes your loan NPV as low as you possibly can, you’re going to be adding steadily to your kitty, and doing the financially smart thing.
How to make use of this number in determining your path
It’s one thing to know that the NPV is the magic number you’re looking to optimize, and quite another to actually calculate it accurately with a “model” and use it to make your decision.
Having built one of these models myself, I can tell you it’s not something you finish in an hour, while taking your lunch break. (Well, maybe it is for you, but it definitely was not for me – took me a good few weeks to get the thing built out).
But you don’t have to have a whole fancy machine built out to take advantage of this knowledge.
You can use decent rules of thumb that allow you to make good guesses about what the impact of a specific strategy will be on your loan’s overall NPV.
The rules of thumb
Briefly, anything that increases the total amount you have to pay on the loan will generally increase your loan’s NPV. Also, anything that makes you pay sooner rather than later will also increase your NPV So:
- Stretching out the number of years you have to make loan payments
- Increasing the interest on a loan
- Not having any options for loan forgiveness
- Increasing the number of years you have before the loan can be forgiven
will all result in a higher NPV, all else being equal.
On the other hand:
- Loan forgiveness (even if you have to pay some taxes on the forgiven amount)
- Reducing the number of years over which you pay
- Increasing the monthly payment without increasing the interest rate
- Reducing the number of years you need to make payments before qualifying for loan forgiveness
will all reduce the total amount you end up paying on your loan, and will therefore reduce you overall NPV
When picking strategies, pick the ones that will
- Reduce term of the loan
- Reduce the interest rate
- Reduce fees and costs
- Increase forgiveness options, especially if the forgiveness is tax-free (like the PSLF program)
- Accelerate payments without changing interest rate
- Make you eligible for forgiveness sooner, rather than later
Doing so will continue to hammer down your NPV, which means you will end up with more of your hard-earned dollars left in your pocket to fund the life you really want to live.
If you want more specificity, I offer one-on-one consultations that will take your specific loan scenario into account and develop recommendations to reduce your overall NPV. Find more details here.
In the meanwhile, go forth and hunt hard for those NPV killers!