Student loans study: ‘Best’ option is paying more now so you owe less later

BOULDER, Colo. — Student debt is a reality of life for millions of Americans. While payment obligations and interest rates have been frozen since the start of the COVID pandemic, that leeway is scheduled to end this October. Now, researchers from the University of Colorado at Boulder claim to have found the optimal way to pay off student loans.

Generally speaking, when it comes to paying off student loans there are two main options. The first is to pay off the debt as soon as possible, thus saving a significant amount on interest. That’s the easiest solution, but it isn’t financially doable for millions of borrowers. So, many people choose to enroll in an income-based repayment plan instead. Such plans allow borrowers to make a smaller monthly payment each month, but also lead to students paying much more due to interest rates. The team at UCB, however, say they’ve uncovered a third option.

Researchers say some borrowers should consider combining both approaches. Pay off as much as you can to start and then enroll in an income-based repayment plan.

“The rule of thumb is that if your balance is really small, just pay it as quickly as possible, and if your balance is large, then enroll in an income-based scheme right away,” says study co-author Yu-Jui Huang, a CU Boulder assistant professor of applied mathematics, in a university release. “We find that, between these two extremes, there’s actually a third strategy, which is, you should pay as much as possible over the first several years. And after that, switch to an income-based repayment scheme.”

Owing interest can lead to student loans that seem never-ending

Researchers created a complex mathematical model capable of considering each individual loan borrower’s situation during this project. According to Prof. Huang, this is likely the first time scientists have applied such a model to student debt. While this certainly isn’t the first study to investigate student loans, most prior research has focused on the real-world effects of student debt on individuals and the greater U.S. economy. This work instead chose to prioritize answering one question: “What’s the best way to pay off a student loan?”

“We made the model as simple as possible,” Prof. Huang notes. “For many students, this can save them money.”

While it’s true that income-based repayment plans offer loan forgiveness after 25 years of monthly payments, borrowers must pay income tax on whatever they ultimately don’t pay off. Add in the fact that interest rates mean a person’s student debt literally grows a little bigger every single day, and it’s easy to understand why millions of Americans feel confused and frustrated about how to approach their debt.

So, the research team focused on identifying when borrowers should stop making regular payments and switch to an income-based repayment plan. Study authors refer to this period as the critical horizon.

“The critical horizon is the time at which the benefits of forgiveness match the costs of compounding,” study authors write.

Trying to find certainty in an uncertain future

The team at UCB have already begun working on improving their model. For instance, future versions should account for “randomness” more accurately. The current version asks borrowers to give their best guess at what their income and living expenses will look like years down the line. However, life rarely plays out exactly as envisioned or planned. Moreover, researchers say further study on other lifestyle factors and developments influencing the motivation to pay off student debt is needed as well. For example, does having children or purchasing a home change one’s critical horizon time window?

“In practice, what people say is, ‘Yes, I’m going to be a dentist. Looking at past data, I know my starting salary should be this and, after a few years, my salary should grow to this particular stage and so on,'” Prof. Huang adds. “The purpose of introducing the randomness here is because some dentists become really rich in five or 10 years, and some others are not so rich. Even if you look at the data, you can’t be quite sure which category you will eventually fall into.”

There are no current plans to make this model widely available to student loan borrowers. However, Prof. Huang and his team say they’re open to existing student loan repayment calculators adopting their work.

“Right now, students don’t really have any kind of concrete or rigorous guidelines–they may just have these general impressions but there’s no math to justify those,” he concludes. “We have created a simple model, but one that’s undergone a very rigorous mathematical treatment.”

The study is published in the SIAM Journal on Financial Mathematics.

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