Financial Topics Archives | Page 618 of 808

Jun

2023

What is a Covered Call ETF: Strategies & Benefits

Pros and Cons of a Covered Call ETF — and When to Buy

By Brian Nibley | Growing Wealth, Investing | Comments Off

A covered call ETF is an exchange-traded fund that provides investors with additional income by writing options on the securities the ETF holds. These actively-managed ETFs offer investors the benefits of writing call options on stocks, without them having to participate in the options market directly.

The upside is that investors take on less risk and potentially earn income in the form of options contract premiums on top of dividends. The downside is that potential upside profits will be capped because the call options will have to be exercised once the underlying security reaches a certain strike price (one of many options trading terms to know), at which point the shares will be called away from the shareholder.

Basics of the Covered Call Strategy

Covered calls involve buying shares of a stock and then writing call options contracts on some of those shares. A covered call could also be referred to as “call writing” or “writing a call option” on a security.

Other investors can then purchase the call option contract. They pay a small fee to the call writer, known as a premium, for doing so. The contract gives a buyer of the option the right, but not the obligation, to buy shares at a specific price on or before a specified date.

In the case of call options, when the share price of the underlying security rises above the strike price, an option holder can choose to exercise the option, at which point the stock will be called away from the person who wrote the call option.

The option holder then receives shares at a cost lower than current market value. Their profits will equal the difference between the option strike price and where the stock is currently trading minus the premium paid. The higher the stock price rises before the expiry date, the greater the profit for the person holding the call option.

Because the call option writer receives income on the deal in the form of a premium, they want the stock price to either stay flat, fall, or rise only slightly. If the stock rises beyond the strike price of the option, then they’ll receive the premium, but their shares will be called away. The option writer will have a gain or loss depending on the difference of the exercise price and the purchase price of the stock and the premium received.

On the other hand, if the stock doesn’t reach the strike price of the option, then the writer keeps both the premium and the shares. They’re then free to repeat the process as many times as they wish.

💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

What Is a Covered Call ETF?

A covered call ETF is an actively-managed exchange-traded fund (ETF) that buys a set of stocks and writes call options on them — engaging in the call-writing process as much as possible in order to maximize returns for investors.

By investing in a covered call ETF, investors have the opportunity to benefit from covered calls without directly participating in the options market on their own. The fund takes care of the covered calls for them.

The ETF covered call strategy usually involves writing short-term (under two-month expiry) calls that are out-of-the-money (OTM), meaning the security’s price is below a call option’s strike price. Using shorter-term options allows investors to take advantage of rapid time decay.

Options like these also serve to create a balance between earning high amounts of premium payments while increasing the odds that the contracts will expire OTM (which, for covered call writers, is a positive outcome).

Writing options OTM serves to make sure that investors can benefit from some amount of the upward price potential of the underlying securities.

When to Buy a Covered Call ETF

It may be a good time to buy a covered call ETF when most of the securities held by the ETF are expected to trade sideways or go down slightly for some time. Beyond that, any time is a good time for investors who find the strategy appealing, want to take the chance of gaining extra income for their portfolios, and don’t mind missing out on outsized gains if the market rips higher.

Covered call ETFs might also be attractive to people nearing retirement, people who are generally more risk-averse, or anyone looking to add some additional income to their portfolio without having to learn how to write and trade options.

If an investor were considering ETFs vs. index funds, they might choose an ETF for the reason that the fund might employ creative strategies like covered calls, whereas index funds merely try to track an index.

When Not to Buy a Covered Call ETF

The one time when it may be advisable not to buy a covered call ETF might be when stocks are generally rising and making new record highs on a regular basis. This is a scenario where covered call ETFs would underperform the rest of the market.

If the underlying securities rise only slightly, and do not exceed the strike prices set for the covered calls, then these ETFs should also perform well. It’s only when stocks rise to the point that the shares get called away from the fund that the fund will almost certainly underperform compared to holding shares directly.

Pros and Cons of a Covered Call ETF

The main benefits that come from taking advantage of an ETF covered call strategy are reduced risk and increased income.

Pros of a Covered Call ETF

Overall, a covered call ETF has largely the same risk profile as holding the underlying securities would. But some investors see these ETFs as less risky than holding individual stocks because the ETF should, in theory, do as well or slightly better than the market in most situations. (The one exception would be during extended, strong bull markets.)

But while covered call ETFs reduce the risk associated with owning a lot of shares while also providing additional income, hedging against downside risk would best be accomplished by using put options.

Cons of a Covered Call ETF

Covered call ETFs are actively managed, which means they tend to have higher expense ratios than passively managed ETFs that track an index. But the extra income may potentially offset that cost.

The Takeaway

A covered call ETF is an actively managed exchange-traded fund that offers investors the benefits of writing call options on stocks, without them having to participate directly in the options market. For investors looking for a simpler approach, this may be beneficial. Covered call ETFs also have two primary benefits in reduced risk and increased income.

That’s not to say that they don’t have downsides, too. Notably, they tend to be actively-managed, which generally means they have higher associated fees. Again, all of this should be taken into consideration before folding any type of security into an investment strategy.

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Jun

2023

Tail Risk Explained: Woman investing on phone

Tail Risk, Fat Tails, and What They Mean for Investors

By Colin Dodds | Growing Wealth, invest, Investing | Comments Off

Tail risk is the danger of large investment gains or losses because of sudden and unforeseen events. The term “tail risk” refers to the tails on a bell curve: While the fat middle of the bell curve represents the most probable returns, the tails — both positive and negative — represents the least likely outcomes.

When looking at the bell curve that gives the phenomenon its name, investors sometimes also refer to tail risk as “left-tail risk,” as it refers to the very unlikely and very negative outcomes on the curve.

What Is Tail Risk?

Tail risk is defined by a concept called standard deviation. As a metric, standard deviation shows how widely the price of an asset fluctuates above and below its average. For a volatile stock, the standard deviation will be high, while the standard deviation for a stock with a steady value will be low.

Standard deviation is an important number that investors use to understand how historically volatile a stock is, as well as the level of volatility they can project for it in the future. That projection is based on the underlying assumption that the price changes of a stock will follow the pattern of what’s called normal distribution.

Normal distribution is a statistical term used to describe the probability of an event, and it shapes the bell curve. If you flip a coin 10,000 times, how often will it land on heads or tails? Each time, there is a 50% probability it will land on heads or tails, and the curve describes the likelihood that those 10,000 flips will come out 50/50. The fat middle of the curve says it will be close to 50/50, but there are extremely low probabilities at the low (or skinny) ends of the bell curve that it could be more like 80/20 heads or 80/20 tails.

That approach to probability predicts that a stock selling at a mean price of $45 with a $5 standard deviation is 95% certain to sell between $35 and $55 at the close of that day’s market.

“Tail risk” is used to describe the risk that an investment will fall or rise by more than three standard deviations from its mean price. To continue the example, the hypothetical stock $45 stock has entered the domain of tail risk if, at the end of the trading day, it is priced at $30 or below, or at $60 or above.

💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

What are Fat Tail Risks?

Unpredictable events are ironically predictable, and happen in the markets on a regular basis. And those markets, such as the one following the onset of the pandemic in early 2020, exhibit much “fatter” tails. Another period characterized by having an extremely fat tail was the 2008 Financial Crisis.

They’re called “fat tails” because the outcomes that had been on the extremes were suddenly happening, instead of the ones previously considered probable. This condition is also called by the mathematical term leptokurtosis. As a general rule, because they deviate so wildly from the expected norm, fat tail events present great risk as well as great opportunities for investors.

Tail Risk Strategy

Financial models such as Harry Markowitz’s modern portfolio theory (MPT) or the Black-Scholes Merton option pricing model, employ the assumption that the returns of a given asset will remain between the mean and three standard deviations.

The assumptions made in these long-term market projections can help with planning. But they’re not realistic about how investors receive their market returns over the long term. Rather, the bulk of their returns, no matter how diversified their portfolio, are largely the result of positive tail events. The power of tail events over long periods is one reason that experts tell investors to stay in the markets during fat-tail periods of volatility, even if it is stressful at the time.

Why Investors Hedge Tail Risks

Left-tail events also have the potential to have an extremely negative impact on portfolios. That’s why many investors hedge their portfolios against these events — aiming to improve long-term results by reducing risk. But these strategies necessarily come with short-term costs.

Downside Protection

One strategy that’s designed to protect against tail risks involves taking short positions that counterbalance the rest of a portfolio, also known as buying downside protection. For example, if an investor is heavily invested in U.S. equities, they may consider investing in derivatives on the Chicago Board Options Exchange (CBOE) Volatility Index (VIX), which correlates to the inverse of the S&P 500 index. (Using short strategies is also one way to invest during a bear market.)

Another way to hedge by buying downside protection is to purchase out-of-the-money put options. When the assets connected to these put options go down, the put options become more valuable. Granted, buying those options costs money, but it can be a strategy to consider for investors who believe the markets are likely to be volatile for a while.

Tail Risk Parity

Tail risk parity is a way to structure a portfolio based on the expectations that events that have a negative impact on one asset class will likely be a boon to others. This requires looking at each asset class in terms of how it might fare in the event of a particular crisis, and then finding an asset class that would likely do well in that same circumstance, and then keeping them in balance within your portfolio.

Managed Futures Funds

Other investors who want to trim their exposure to tail risks may invest in managed futures funds. These funds buy long and short futures contracts in equity indexes, and can thrive during times of crisis in the markets.

The Takeaway

A tail risk is the risk that an event with a low likelihood of happening will happen. And it’s something that investors need to keep in mind. There are a few different ways to mitigate the impact of tail risk in an investment portfolio, but for long-term investors, it can be helpful to keep in mind that tail risk is responsible for most returns over time.

Tail risk and fat tails may seem like granular investing terms, but they do play a role in the markets, which means that every investor can benefit from learning about them, and how they can affect a portfolio.

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

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Jun

2023

How to Choose a 401(k) Beneficiary: Rules & Options

By Lauren Ward | Growing Wealth, invest, Investing, Preparing for Retirement | Comments Off

Choosing a 401(k) beneficiary ensures that any unused funds in your account are dispersed according to your wishes after you pass away. Whether you’re married, single, or in a domestic partnership, naming a beneficiary simplifies the estate process and makes it easier for your heirs to receive the money.

There’s room on 401(k) beneficiary forms for both a primary and contingent beneficiary. Before making any decisions on a beneficiary and a backup, it can help to familiarize yourself with 401(k) beneficiary rules and options.

Why It’s Important to Name 401(k) Beneficiaries

A 401k account is a non-probate asset. That means it doesn’t have to go through the lengthy probate legal process of distributing your property and assets when you die — as long as you name a beneficiary.

If you die without a beneficiary listed on your 401(k) account, the distribution of the account may have to go through probate, which can take months.

Some plans with unnamed beneficiaries automatically default to a surviving spouse, while others do not. If that’s the case — or if there is no surviving spouse — the 401(k) account becomes part of the estate that goes through probate as part of the will review.

The amount of time it will take for your heirs to go through the probate process varies depending on the state and depends on the complexity of your assets. At a minimum, it can last months.

Another downside of having your 401(k) go to probate instead of being directly inherited by a beneficiary is that the account funds could be used to pay off creditors (if the deceased had unpaid debts that can be covered by the estate).

By naming a 401(k) beneficiary, you ensure your heirs receive the funds in full, especially if you weren’t legally married but want to insure that your domestic partner is your legal beneficiary. A beneficiary designation is currently required in order for your domestic partner to inherit your 401(k).

Having named 401(k) beneficiaries is a decision that overrides anything written in your will, as well as court orders, so it’s important to review your beneficiaries every few years, to make sure your money goes to the person or organization you choose.

What to Consider When Choosing a Beneficiary

Your 401(k) account may hold a substantial amount of your retirement savings. How you approach choosing a 401(k) beneficiary depends on your personal situation. For married individuals, it’s common to choose a spouse. Some people choose to name a domestic partner or your children as beneficiaries.

• Your primary beneficiary is the main person or organization who you want to receive your 401(k) assets when you die.

• The contingent beneficiary (aka the secondary beneficiary) will inherit the assets if your primary beneficiary can’t or won’t.

Another option is to choose multiple beneficiaries, like multiple children or siblings. In this scenario, you can either elect for all beneficiaries to receive equal portions of your remaining 401(k) account, or assign each individual different percentages.

For example, you could allocate 25% to each of four children, or you could choose to leave 50% to one child, 25% to another, and 12.5% to the other two.

In addition to choosing a primary beneficiary, you must also choose a contingent beneficiary. This individual only receives your 401(k) funds if the primary beneficiary passes away or disclaims their rights to the account. If the primary beneficiary is still alive, the contingent beneficiary doesn’t receive any funds.

401(k) Beneficiary Rules and Restrictions

Really, an individual can choose anyone they want to be a 401(k) beneficiary, with a few limitations.

• Minor children cannot be direct beneficiaries. They must have a named guardian oversee the inherited funds on their behalf, which will be chosen by a court if not specifically named. Choosing a reliable guardian helps to ensure the children’s inheritance is managed well until they reach adulthood.

• A waiver may be required if someone other than a spouse is designated. Accounts that are ruled by the Employee Retirement Income Security Act (ERISA) have 401(k) spouse beneficiary rules. A spousal waiver is required if you designate less than 50% of your account to your spouse. Your plan administrator can tell you whether or not this rule applies to your specific 401(k).

How to Name Multiple 401(k) Beneficiaries

You are allowed to have multiple 401(k) beneficiaries, both for a single account and across multiple accounts. You must name them for each account, which gives you flexibility in how you want to pass on those funds.

When naming multiple beneficiaries, it’s common practice to divide the account by percentage, since the dollar amounts may vary based on what you use during your lifetime and investment performance.

Complex Rules for Inherited 401(k)s

You may also want to consider how the rules for an inherited 401(k) may affect a beneficiary who is your spouse vs. a non-spousal beneficiary.

Spouses usually have more options available, but they differ depending on the spouse’s age, as well as the year the account holder died.

In many cases, the spouse may roll over the funds into their own IRA, sometimes called an inherited IRA. Non-spouses don’t have that option. In most cases a non-spouse beneficiary must withdraw all the funds from the account within 10 years.

A beneficiary can also take out the money as a lump sum, which will be subject to ordinary income tax. But you need to be at least age 59 ½ in order to avoid the 10% early withdrawal penalty.

Because the terms governing inherited 401(k) are so complex, it may be wise to consult a financial professional.

What to Do After Naming Beneficiaries

Once you’ve selected one or more beneficiaries, take the following steps to notify your heirs and to continually review and update your decisions as you move through various life stages.

Inform Your Beneficiaries

Naming your beneficiaries on your 401(k) plan makes sure your wishes are legally upheld, but you’ll make the inheritance process easier by telling your beneficiaries about your accounts. They’ll need to know where and how to access the account funds, especially since 401(k) accounts can be distributed outside of probate, making the process much faster than other elements of your estate plan.

For all of your accounts, including a 401(k), it’s a good idea to keep a list of financial institutions and account numbers. This makes it easier for your beneficiaries to access the funds quickly after your death.

Impact of the SECURE Act

You also need to inform beneficiaries about the pace at which the funds must be dispersed after your death.

Thanks to the terms in the SECURE Act (Setting Every Community Up for Retirement Enhancement), beneficiaries generally must withdraw all assets from an inherited 401(k) account within 10 years of the original account holder’s death. Some beneficiaries are excluded from this requirement, including:

• Surviving spouses

• Minor children

• Disabled or chronically ill beneficiaries

• Beneficiaries who are less than 10 years younger than the original account holder

Revise After Major Life Changes

Managing your 401(k) beneficiaries isn’t necessarily a one-time task. It’s important to regularly review and update your decisions, especially as major life events occur. The most common events include marriage, divorce, birth, and death.

Common Life Stages

Before you get married, you may decide to list a parent or sibling as your beneficiary. But you’ll likely want to update that to your spouse or domestic partner, should you have one. At a certain point, you may also wish to add your children, especially once they reach adulthood and can be named as direct beneficiaries.

Divorce

It’s particularly important to update your named beneficiaries if you go through a divorce. If you don’t revise your 401(k) account, your ex-spouse could end up receiving those benefits — even if your will has been changed.

Death of a Beneficiary

Should your primary beneficiary die before you do, your contingent beneficiary will receive your 401(k) funds if you pass away. Any time a major death happens in your family, take the time to see how that impacts your own estate planning wishes. If your spouse passes away, for instance, you may wish to name your children as beneficiaries.

Second Marriages and Blended Families

Also note that the spouse rules apply for second marriages as well, whether following divorce or death of your first spouse. Your 401(k) automatically goes to your spouse if no other beneficiary is named. And if you assign them less than 50%, you’ll need that spousal waiver.

Financial planning for blended families takes thought and communication, especially if you remarry later in life and want some or all of your assets to go to your children.

Manage Your Account Well

Keep your 401(k) beneficiaries in mind as you manage your account over the years. While it is possible to borrow from your 401(k), this can cause issues if you pass away with an outstanding balance. The loan principal will likely be deducted from your estate, which can limit how much your heirs actually receive.

Also try to streamline multiple 401(k) accounts as you change jobs and open new employer-sponsored plans. There are several ways to roll over your 401(k), which makes it easier for you to track and update your beneficiaries. It also simplifies things for your heirs after you pass away, because they don’t have to track down multiple accounts.

How to Update 401(k) Beneficiaries

Check with your 401(k) plan administrator to find out how to update your beneficiary information. Usually you’ll need to just fill out a form or log into your online retirement account.

Typically, you need the following information for each beneficiary:

• Type of beneficiary

• Full name

• Birth date

• You may also need their Social Security number

Although your named beneficiaries on the account supersede anything written in your will, it’s still smart to update that document as well. This can help circumvent legal challenges for your heirs after you pass away.

The Takeaway

A financial plan at any age should include how to distribute your assets should you pass away. The best way to manage your 401(k) is to formally name one or more beneficiaries on the account. This helps speed up the process by avoiding probate.

A named beneficiary trumps anything stated in your will. That’s why it’s so important to regularly review these designations to make sure the right people are identified to inherit your 401(k) assets.

It’s true that you will likely use your 401(k) funds yourself, for your retirement. But because an inherited 401(k) can be a significant asset, beneficiaries will likely face certain income and/or tax consequences when they inherit it. Thus, it’s best to inform the people whom you’re choosing.

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

Jun

2023

Intrinsic Value vs Market Value, Explained

By Inyoung Hwang | Growing Wealth, invest, Investing, Terminology | Comments Off

Intrinsic value vs. market value refers to the difference between where a stock is currently trading and where it perhaps ought to be, according to its fundamentals. The term “market value” simply refers to the current market price of a security. Intrinsic value represents the price at which investors believe the security should be trading at. Intrinsic value is also known as “fair market value” or simply “fair value.”

When it comes to value vs. growth stocks, value investors look for companies that are out of favor and below their intrinsic value. The idea is that sooner or later stocks return to their intrinsic value. That’s why it can be important to understand the differences and help it inform your strategy.

What Is Market Value?

In a sense, there is only one measure of market value: what price the market assigns to a stock, based on existing demand.

Market value tends to be influenced by public sentiment and macroeconomic factors. Fear and greed are the primary emotions that drive markets. During a stock market crash, for example, fear may grip investors and the market value of many stocks could fall well below their fair market values.

News headlines can drive stock prices above or below their intrinsic value. After reading a company’s annual report that’s positive, investors may pile into a stock. Even though better-than-expected earnings might increase the intrinsic value of a stock to a certain degree, investors can get greedy in the short-term and create overextended gains in the stock price.

The rationale behind value vs price, and behind value investing as a whole, is that stocks tend to overshoot their fair market value to the upside or the downside.

When this leads to a stock being oversold, the idea is that investors could take advantage of the buying opportunity. It’s assumed that the stock will then eventually rise to its intrinsic value.

💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

What Is Intrinsic Value?

The factors that can be used to determine intrinsic value are related to the fundamental operations of a company. It can be tricky to figure out how to evaluate a stock. Depending on which factors they examine and how they interpret them, analysts can come to different conclusions about the intrinsic value of a stock.

It’s not easy to come to a reasonable estimation of a company’s valuation. Some of the variables involved have no direct physical, measurable counterpart, like intangible assets. Intangible assets include things like copyrights, patents, reputation, consumer loyalty, and so on. Analysts come to their own conclusions when trying to assign a value to these assets.

Tangible assets include things like cash reserves, corporate bonds, equipment, land, manufacturing capacity, etc. These tend to be easier to value because they can be assigned a numerical value in dollar terms. Things like the company’s business plan, financial statements, and balance sheet have a tangible aspect in that they are objective documents.

💡 Quick Tip: Newbie investors may be tempted to buy into the market based on recent news headlines or other types of hype. That’s rarely a good idea. Making good choices shouldn’t stem from strong emotions, but a solid investment strategy.

Calculating Intrinsic Value vs Market Value

There can be multiple different ways to determine the intrinsic value of an asset. These methods are broadly referred to as valuation methods, or using fundamental analysis on stocks or other securities. The methods vary according to the type of asset and how an investor chooses to look at that asset.

Calculating Intrinsic Value

For dividend-yielding stocks, for example, the dividend discount model provides a mathematical formula that aims to find the intrinsic value of a stock based on its dividend growth over a certain period of time. Dividends are periodic income given to shareholders by a company.

Upon calculating the dividend discount model, an investor could then compare the answer to the current market value of a stock. If market value were to be lower, then the stock could be seen as undervalued and a good buy. If market value were to be higher, then the stock could be seen as overvalued and not worth buying or possibly an opportunity to sell short.

Another method for estimating intrinsic value is discounted cash flow analysis. This method attempts to determine the value of an investment in terms of its projected future cash flows.

While the dividend discount model and discounted cash flow analysis can be seen as objective ways to determine a stock’s value, they also have a large subjective component. Analysts must choose a timeframe to use in their model. Using different timeframes can lead to different conclusions.

Longer timeframes are often thought of as being more accurate because they include more data points. But they could also dilute the significance of more recent trends.

Example Using Dividend Discount Model

For example, if a company had years of steady dividend growth, but recently slashed its dividend by 50%, a dividend discount model analysis based on a long timeframe would show this reduction in dividend payments to be less severe than an analysis based on a shorter time frame.

The longer timeframe would include previous years of dividend growth, which would theoretically outweigh the recent reduction.

The reduction may have come from a large decrease in earnings. If that trend were to continue, the company could be doomed to the point of having to suspend its dividends. So in this hypothetical example, a shorter time frame could actually lead to a more realistic conclusion than a longer one.

Calculating Market Value

The determination of market value is rather simple by comparison. Someone can either simply look at what price a stock is trading at or calculate its current market capitalization. The formula for market capitalization or market cap is:

Total number of outstanding shares multiplied by the current stock price.

Dividing market cap by number of shares also leads to the current stock price.

Sometimes companies engage in “corporate stock buybacks,” whereby they purchase their own shares, which reduces the total number of shares available on the market.

This increases the price of a stock without any fundamental, tangible change taking place. Value investors might say that stocks pumped up by share buybacks are overvalued. This process can lead to extreme valuations in stocks, as can extended periods of market euphoria.

The Takeaway

Intrinsic value and market value describe the values of a security as they’re currently trading versus where their underlying fundamentals suggest they should be trading. Using the intrinsic value vs market value method is likely best suited to a long-term buy-and-hold strategy.

Stock prices can remain elevated or depressed for long periods of time depending on market conditions. Even if an investor’s analysis is spot on, there’s no way to know for sure exactly when any stock will return to its intrinsic value. That’s critical to understand if you hope to utilize intrinsic value vs market value in your own investing strategy.

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

Jun

2023

How Does Student Loan Deferment in Grad School Work?

By Jody McMaster | Fresh Out of School, Student Loans, student_loan | No Comments

Attending graduate or professional school requires careful consideration so that you don’t end up with a heavier student debt burden than you planned for.

That means not only having a plan for graduate school loans but knowing what to do with any existing undergraduate student loans. One question many potential grad students may have is, if I go to graduate school, will my loans be deferred?

You could defer loans while in grad school for temporary relief, but loan refinancing or an income-driven repayment plan could bring longer-term help.

Read on to learn more about how to defer student loans while in grad school, and other alternatives to consider.

Deferment vs Forbearance

Graduation from undergrad or graduate school is followed by a payment grace period of six months for most federal student loans. But if you hit a snag at some point and can’t afford payments, both deferment and forbearance are designed to allow you to apply to postpone payments.

The main difference between the two: Interest accrues on only some federal student loans during deferment, whereas it accrues on nearly all of them in forbearance. Any unpaid interest is capitalized, or added to your loan balance, at the end of the payment pause, increasing the total amount you end up repaying.

To answer the question of, if I go to graduate school, will my loans be deferred?, it is possible to do, as long as you qualify for deferment.

Deferment, for up to 12 months at a time, for a maximum of 36 months, may be a better choice than forbearance if:

• You have subsidized federal student loans and

• You’re dealing with substantial financial hardship

If you apply to defer student loans while in grad school and don’t qualify, and your financial hardship is temporary, forbearance is an option.

If you have private student loans, many lenders will allow you to apply for a payment pause during hardship, too, though the terms and fees may be less borrower-friendly than is the case with federal student loans.

Do I Qualify to Defer My Payments?

Here’s how to defer student loans while in grad school: For federal student loans, you’ll need to submit a request to your student loan servicer, usually with documentation to show that you meet the eligibility requirements for the deferment. For private student loans, you’ll need to check the rules directly with the lender.

A variety of circumstances may qualify you for deferment. These are several of them.

Economic Hardship Deferment

You:

• Are receiving a means-tested benefit, like welfare

• Work full-time but have earnings that are below 150% of the poverty guideline for your family size and state

• Are serving in the Peace Corps

Unemployment Deferment

You receive unemployment benefits or you are unable to find full-time employment.

Graduate Fellowship Deferment

You’re enrolled in a graduate fellowship program that provides financial support while you pursue graduate studies and research.

Military Service and Post-Active Duty Student Deferment

You are on active duty military service in connection with a war, military operation, or national emergency; or you’ve completed active duty service and any grace period.

Rehabilitation Training Deferment

You’re enrolled in an approved program that provides mental health, drug abuse, alcohol abuse, or vocational rehab.

Cancer Treatment Deferment

You may qualify for deferment while undergoing cancer treatment and for six months afterward.

When Interest Accrues in Deferment

If you’re looking into defer student loans while in grad school, you’ll want to check how interest would be handled during the payment pause and whether, if unpaid interest is capitalized, you’re prepared to take on a higher overall cost of the loan.

During deferment, you are generally not responsible for paying interest on:

• Direct Subsidized Loans

• Federal Perkins Loans

• The subsidized portion of Direct Consolidation Loans

• The subsidized portion of Federal Family Education Loan (FFEL) Program Consolidation Loans

With deferment, you are generally responsible for paying interest on:

• Direct Unsubsidized Loans

• Direct PLUS Loans

• FFEL PLUS Loans

• The unsubsidized portion of Direct Consolidation Loans

• The unsubsidized portion of FFEL Consolidation Loans

• Private student loans (if the lender allows deferment)

If you’re starting graduate or professional school or are in the thick of it, your federal borrowing options are Direct PLUS Loans (commonly called grad PLUS Loans when borrowers are graduate students) and Direct Unsubsidized Loans (also available to undergrads).

As noted above, those loan types accrue interest during a deferment.

Direct loans for graduate students currently carry a 7.54% rate (the rates are set by federal law for each academic year), with a loan fee of 4.228%.

Nongovernment lenders may offer private graduate student loans, sometimes with a fixed or variable rate and no loan fee.

Something to consider: If you pursue deferment on loans in the second category above to manage costs while in grad school, it’s a good idea to at least consider making interest-only payments during the deferment.

Options to Deferment in Grad School

There are at least two other ways, beyond forbearance, to get a handle on student loan payments in grad school.

Income-Driven Repayment

Some graduate students who have federal student loans might want to consider switching, even temporarily, to an income-based repayment plan.

Your monthly payment would be tied to family size and income, which may be low for a graduate student enrolled full time.

The four income-driven repayment plans stretch payments over 20 or 25 years, after which any remaining balance is supposed to be forgiven. After graduation, you could switch the student loan repayment plan back to the standard 10-year plan.

Though borrowers often pay less each month using one of these plans, they’ll generally pay more in total interest over the duration of the drawn-out loan.

The good news is that new federal regulations will prevent interest from accruing in certain situations with these plans. For example, previously, a monthly payment might have been less than the amount to cover interest on your loans. That unpaid interest was added to the amount you borrowed, and the amount you owed increased. However, under the new rules, excess interest will no longer accrue starting in July 2023, which could save you money.

In addition, any student debt that was forgiven used to be taxed as ordinary income, but the 2021 COVID relief package put a stop to that at the federal level, at least through 2025.

Refinancing

Another way to potentially lower your monthly payments without deferring your loans (and accruing interest) is by refinancing your student loans. Note: You may pay more interest over the life of the loan if you refinance with an extended term.

With student loan refinancing, a private lender pays off your loans (both federal and private) with one new loan, ideally with a lower interest rate.

A decrease in an interest rate while maintaining the loan’s duration is a compelling way to both save money each month and over the life of the loan. To understand how a change of even 1% can affect how much interest you’ll pay on a loan over time, you can use this student loan refinance calculator.

Should you refinance your student loans, it’s important to first understand that you’ll lose access to federal programs such as income-driven repayment and loan forgiveness as well as future benefits applicable to federally held loans. Be sure to consider this carefully before refinancing.

Private lenders may or may not have a deferment option.

Lenders that offer student loan refinancing typically require a good credit history and a steady income, among other factors. A student loan refinancing guide can help you learn more about the process.

The Takeaway

Student loan deferment before or during grad school could bring temporary relief. It could also add unpaid interest to loans and create a bigger balance to pay off. Those looking to manage payments long term may want to look into alternatives.

One option is student loan refinancing. SoFi offers low fixed and variable rates, flexible terms, and no fees for refinancing student loans.

Plus, as a SoFi member, you’ll have access to a professional-grade list of benefits like career coaching and financial advice.

See what interest rate you may qualify for in just minutes.

SoFi Student Loan Refinance
SoFi Student Loans are originated by SoFi Bank, N.A. Member FDIC. NMLS #696891. (www.nmlsconsumeraccess.org). SoFi Student Loan Refinance Loans are private loans and do not have the same repayment options that the federal loan program offers, or may become available, such as Public Service Loan Forgiveness, Income-Based Repayment, Income-Contingent Repayment, PAYE or SAVE. Additional terms and conditions apply. Lowest rates reserved for the most creditworthy borrowers. For additional product-specific legal and licensing information, see SoFi.com/legal.

SoFi Loan Products
SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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