Question: I am in my final year of studies and have around $60,000 in student debt at around 5-per-cent interest rate. The loan is with the Alberta government and a small portion with the federal government but I go to school at the University of Toronto. I am considering getting a line of credit around 3.5 per cent and using that to pay off my student loan. However, in doing this, I will be giving up my tax credits and the chance that one day the Alberta or federal governments may choose to forgive the loan. I also have around $6,000 in a TFSA and will have a steady job starting September at around $70,000 a year. What would you suggest?
Ben Felix is an associate portfolio manager with PWL Capital in Ottawa and a CFA charterholder.
Answer: On an after-tax basis, the interest rate on a 5-per-cent student loan (assuming Ontario residency, and that you have income tax to offset) is more like 4 per cent when the non-refundable federal and provincial tax credits are taken into account. Interest on the line of credit is not generally tax deductible. So rather than the fairly attractive 1.5-per-cent rate advantage, we are talking about 0.50 per cent. With that in mind, let's look at some of the differences between these two types of loans.
Flexibility
Student loans have fixed repayment terms. For Alberta student loans over $6,000, the repayment term is set at 9.5 years. This means that you will have a fixed monthly repayment consisting of a mix of interest and principal such that the loan will be paid off in 9.5 years. Using canlearn.ca's repayment calculator, you can see that your monthly payments would be $668. This is a fixed monthly payment, and if you miss payments it will affect your credit just like missing a payment on any other loan. If your payments do become problematic, you have the option of changing your payment terms so that they are more manageable. In some cases, the government will even help cover your interest. If you continue to struggle over the long term, the government may even step in and help you with your principal repayments. It is unlikely that the repayment assistance programs will be relevant to you based on your expected steady employment.
A line of credit is generally more flexible than a government student loan, requiring only small minimum monthly payments with no fixed repayment term. Those lower minimum payments also mean that you might not be making any progress in paying down your loan, meaning it could potentially drag down your finances for decades. Depending on how disciplined you are, the flexibility of the line of credit could be a challenge. The bank is also less likely to be forgiving if you start having trouble making your loan payments.
You can pay back student loans or the line of credit as fast as you like. There are no pre-payment penalties for either.
The line of credit wins if flexibility is the goal, but that flexibility may be detrimental to your financial health.
Grace period
Alberta student loans have a six-month grace period during which you do not make payments or accrue interest – the same is true for Ontario, but not for British Columbia. The details of provincial student loan programs vary. The federal portion of your loan starts accruing interest as soon as the grace period begins; you still get six months of no payments, but you are accruing interest during that time.
If you chose to pay off your Alberta loan with a line of credit prior to the end of the six-month grace period, you would accrue unnecessary interest. You will be accruing interest on the federal portion of your loan regardless, so paying it off with a line of credit is less of an issue.
The interest-free grace period is a clear advantage of the Alberta student loan over a line of credit, at least for those first six months.
Interest rate
Floating Alberta student loans are at prime (2.7 per cent), floating Canada student loans are at prime plus 2.5 per cent, fixed Alberta student loans are at prime plus 2 per cent, and fixed Canada student loans are at prime plus 5 per cent. The interest rates on the provincial portion of the loan vary from province to province. For example, Newfoundland and Labrador does not charge any interest on student loans. Based on the interest rate described in your question, you are referring to the rate on a fixed Alberta student loan. With rates as low as they are, locking in a fixed rate could end up being beneficial. On the other hand, if you take the floating option at prime on the Alberta portion of your loan, the rate will be very low, even compared with the line of credit. If you plan on paying the loan back quickly, you might be less concerned with the potential for rising rates, and the floating rate Alberta loan could be a great option.
Lines of credit generally have floating interest rates. At 3.5 per cent floating, you might be better off with the floating provincial student loan at prime, especially when the tax credits on the student loan interest are taken into account. The line of credit may have an advantage over the federal portion of your loan.
For someone who is interested in paying their loan back, the Alberta student loan is at an overall advantage compared with the line of credit. The line of credit could have a slight after-tax interest rate advantage over the federal student loan. The flexibility of the line of credit might be attractive, but it is attractive for all the wrong reasons.
All things considered, it might make sense for you to pay off the federal portion of your loan with a line of credit, and leave the Alberta portion as is. With your steady employment and relatively high starting salary, you should have no problem making loan payments. You can keep the $6,000 in your TFSA as an emergency fund – you want to target 3-to-6 months of living expenses there. As you start earning income, it might make sense to make your minimum student loan payments and get started with investing at the same time rather than aggressively paying off the loan. As long as interest rates are low, an aggressive portfolio of low-cost index funds will have a higher expected return than the after-tax rate of interest on your student loans.
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