Managing student debt
You or your kids may be entering the "real world" with a college education —and a significant amount of real debt. With the right framework, you can prepare to manage this debt. Making assumptions based on today’s averages, Sal Khan takes you through how you can factor this debt into your budget in a typical month.
What I want to dig in a bit in this video is student debt, and I'll start off with some averages. So at the time of making this video, the average debt, the average balance that an American student graduates with is $27,000.
Now, this isn't necessarily the entire cost of their education. They might have gotten help from other folks. They might have had a work study. Maybe their parents helped out. Maybe they got a scholarship from someone. But this is the average student loan balance, and once again, just an average. Some people might have a lot more than this. Some people might not have any student loan balance.
And the other average is that the average term for a student loan, so this is the time period over which you are expected to pay it off, is 10 years. And once again, these might change over time, but I'll use this as a reasonably good example to frame our discussion. And at the time of making this video, and this is likely to change over time, but the average interest rate is 6.8% at the time of making this video.
There are student loan calculators, payment calculators on the internet. In fact, you could even use mortgage calculators. If say it's a 10-year term, you're borrowing $27,000, and it's a 6.8% interest rate, and you zero out all of the other assumptions, then the payment that you would have – this obviously isn't a mortgage but it's the same idea. You're borrowing a sum amount of money, you have an interest rate, and you want to pay the whole thing off over some type of a term.
So if you were to input all of that into kind of a loan payment calculator, you would get that the average monthly payment, given these assumptions, are going to be a little over $310 per month. And so let's just think a little bit about if we make these assumptions, how easy or hard this might be to pay off, and then we can start to stretch these assumptions a little bit.
What if your balance is four times this, and I know people with balances four times this – in fact, my balance was a lot more than $27,000 – so I looked up some more averages. So this is kind of what you have to pay, this is the debt, so let's think about income and expenses.
So the average – and once again, this is at the time of making this video. I encourage you to look it up just to verify what the averages might be whenever you happen to watch this. But the average income for a college grad at the time of making this – maybe I should write average salary – is $45,000.
And then I looked up the average pay check, which they have as $1,299, and let's see if that actually makes sense. So if I'm making $45,000, and if I assume I have bi-weekly pay checks, so I'm going to have 26. There's 52 weeks in a year, so I'm going to have a pay check on half of them, so I'm going to have 26 pay checks in a year.
That means that my salary before paying taxes and other things is going to be $1,730, and so this actually makes sense. Let's see, if we say 1,299 divided by 1,730, it’s about 75%. So this is assuming that you're paying about 25%. Your effective tax rate is about 25%, and that includes your state, and your federal income tax, and your social security benefits, and all of that, and so this seems actually like the numbers right over here make sense.
But we have a few more averages, so let's see this average pay check, and let's just translate everything to a monthly basis. So this is going to be approximately $2,600 a month, this is your average take-home pay. So if you're making $45,000 and you have all these other assumptions, that means that the average college grad has $2,600 a month to pay all of their expenses, and hopefully also have some savings.
So now let's think about the expense side of things. So most people's largest expense is housing, and the average rent at the time of making this video is $821. Now this is the average across the United States. You could imagine, if you're in a high-rent place like New York or San Francisco, and you're not living with three people in the same room, you're going to have to pay a lot more than this, but let's just go with the averages.
So you have that rent right over there, and now let's just make some other assumptions. Let's say transportation also tends to be a pretty significant expense. Let's say between your car and gas and maintenance, you have to spend $300 a month in transportation. Obviously, you can tweak these assumptions if you think they're too high or too low, or if you want to drive a fancy car, or maybe you could use public transportation and this would be lower.
And then, of course, you have to feed yourself, and so let's say you spend $100 a week, which isn't an exorbitant amount to spend on food. You could probably spend less if you cooked a lot, but let's see, $400 would be per months, four weeks in a month, so you're going to spend $400 a month on food.
And then, let's see, what does that leave you with? That leaves you with, so $2,600 minus $821 minus $300 minus $400, that leaves you with $1,079. Now you might say, "Hey, this is pretty good, I have $1,079," but we have a couple of expenses that we haven't paid for yet. We haven't paid our average student loan balance, so let's subtract that out.
So my previous answer minus $310.72 gets us $768, and you might say, "Okay, well, that's pretty good. I'm saving $768 per month," but of course, we haven't put any fun in here. You haven't gone to the movies yet. You're going to a show or hanging out with friends or whatever it might be, and so if you put an entertainment budget in there, and it depends on I guess how much you like to party, but let's say that that's just $200 a month, $50 a week which sounds actually pretty economical, so that gets you to $568.
So you still have some savings. That's not bad, especially early in your career. If you're able to put some money aside, this is pretty good. Now, what I want to keep in mind is this is given these assumptions. So now let's stretch these assumptions a little bit.
For example, if instead of your student loan being $27,000, if your student loan balance is say 4 times that, and it was $108,000, now all of a sudden this $310 is going to be 4 times as high as well. So that's going to be approximately $1,240, and so if this was your student loan balance, now all of a sudden this world looks a lot worse. Before having fun and before paying off your loans, you only have $1,079, which is less than what you have to pay for your loans.
And now you might say, "Oh, maybe I make more money than that," and that's definitely possible, and especially as you get more and more experience and get more and more skills in the workforce, your income could go more; but you just have to keep in mind that there's an expectation that you pay this. If your balance is $108,000, from the get-go, from the get-go, so it's not even where you're going to get to. It's where you are going to start, you're going to have to find a reasonable way to pay this amount.
The other things that you're going to have to really, really think about are these assumptions right over here. The average salary, you might have a point in time where you're between jobs, where you want to explore something, so that's a very important thing to take into consideration.
And, of course, what we already mentioned, this rent number is an average for the nation but if you live in an urban area, especially an expensive urban area, your rent could be substantially, substantially more than this, and frankly all of your other expenses are probably going to be more than this.
And so you can see when your student loan, when your debt becomes more – and this is a debt number that there are definitely a lot of folks with debt numbers like this – you have to feel comfortable that you're going to be in a situation upon graduation where you can make this type of payment after really your necessities, after food and living and transportation.
So, I'm not saying student debt is good or bad. I tend to think that an education is a very, very good thing. It's a very good investment. It's one of the best assets that you can have, but any asset, you should always be thoughtful about how much you're going to pay for it, and what type of a return you can get, and whether you can pay for it, and so hopefully this just gives you a little bit of a framework for thinking about that.
And as you can imagine, I’m going to tell you that you should use that to pay down your debt, so that you can pay it down as fast as possible. But then you might say, “Well, which debt do I pay down first? Do I just split that $100 four ways to pay off 25 more than each of these minimum payments? Do I pay the largest amount first, the smallest amount first? Do I pay the highest interest first?” And those are all possible ways of doing it. But the mathematically optimal way of doing it is to pay down the highest cost debt first. So that method is often called the high rate method. High rate method – where you want to pay down your highest, your most costly debt first, which in this case is the retail card. So the order in which you would pay it is retail – you would pay all the minimum payments, and then any extra money that you would have, you would put it towards the retail card first, and then once the retail card is paid off, let’s see, the credit card has the next highest interest. So copy and paste. And then these two loans are – they’re already in order – 10% and 5%. So I’m just ordering these from highest interest cost to lowest interest cost.
So in this world, in this world, you would want to essentially rank them in this way. You obviously have to pay their minimum payments every month, which is $200, but then I would take that extra $100 that you have available and put it to the most costly debt. So I would put that extra hundred dollars right over here. And try to pay this one down as fast as possible. Once that is paid off, then I would put any extra you have after the minimum payments to the credit card. And once that’s paid off as well, then to loan A, and then once that’s paid off, to loan B, and hopefully you are then, you might be then debt free. And if you did the high rate method right over here – you would – and you don’t incur any new debt, you would be debt free after 47 months. 47 months – and you would pay an aggregate interest of approximately 39 - $3,904 in interest over those 47 months.
And so you say, okay, [PH 00:03:21] Sal, you know, I get it, this is the mathematically optimal thing to do – to get rid of your most costly thing first, which makes sense and then your next costly thing, and then on and on, but you tell me, you know, psychology matters here and psychology maybe got me into this debt a little bit. So for me, I just don’t like, you know, just having to – my brain always thinking about all of these four pieces of debt. So I, you know, I would just love to maybe not have to worry about four things and get to worrying about three things as soon as possible and then two things as soon as possible. And so if you think that is helpful, there is a method where you say, “Okay, I’m going to pay my smallest balance first, to just get that out of the way.” Now, keep in mind, if that works for you, if that psychologically allows you to say, “Okay, that’s, you know, that $100 is going to make a bigger dent here.” That’s great, and that’s actually called the snowball method. Let me write here.
And the idea is the snowball – you get one debt out of the way and then you snowball into the next. But that, just to be clear, is not mathematically optimal. It will take you longer to pay your debt, and you will pay more interest. But I’ll just write that down because the important thing is is that you feel like the $100, that you should put the $100 to paying down the debt. That you don’t use it for something else. And so the snowball method – snowball method – would order these things differently. Under the snowball method, you would put your – let’s see, your credit card is the smallest loan balance, so let me put that first. So copy and paste. That’s your credit card. Then after that let’s see, you have loan A – you have loan A here, so let me copy and paste that – copy and paste loan A. And then you have loan B. So loan B is – oh actually – yep, then you have loan B. Copy and paste. And then you have your retail card. Then you have your retail card. And you can see why this might not – why this isn’t going to work out well mathematically, because you’re leaving your most expensive – you’re paying just the minimum on your most expensive, on your most expensive debt. And not only is it expensive, it’s expensive on a large amount. But let’s just go through the ...
So, you might find it more psychologically easy to do this method, because you will at least get rid of the credit card debt a lot faster. You’ll get down to three loans – you’ll get down to only three sources of debt versus four much, much faster. So in this situation you would pay down the credit card first, so you would be able to knock these off faster. But just so you make sure, there is a trade-off. In this one, you’re going to – it’s going to take you 54 months to pay off your debt. So seven months longer. More than half a year longer you’re going to be making payments, and you’re going to pay almost – you’re going to pay almost double in interest. You’re going to pay $6,000 – approximately $6,000 dollars in interest in this situation versus – I guess not – I guess almost 50% more. So here you’re paying almost $4,000 in interest. Here you’re paying roughly $6,000 in interest over the 54 months. So the rational – the mathematically rational one to do would be the high rate method, but this is, you know, whatever it does – you know, assuming you have the money, as long as you put it down towards your debt at least you’re making progress, and this is a method that some people might want to use more for psychological purposes. And I have to admit, I have done this, where I just wanted some debt out of the way, so I pay down the small one first. But if you really want to optimize for interest payments and paying down fast, you want to take out your costliest things first.
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