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Repaying Your Student Loans: How to Make the Best Choices for You

Congratulations!  You’ve just completed four years of undergraduate study and two years of graduate school.  Armed with a master’s degree and a superb education, you’ve landed that coveted first job on your career path.  Now for the bad news:  the job pays $50,000, and you have $100,000 in student loan debt averaging 6% interest.  Your loan servicer  kindly informs you that your payments will amount to $1,110 per month for the next 10 years.  That’s more than one-third of your entire monthly take-home pay, after taxes and other withholdings.  That’s $133,225 in total payments.  Now what?

Repayment Options—The Overview

               Millions of student loan borrowers face dilemmas like that one every day.  As teenagers or young adults in their early 20s, many had no idea what it meant to borrow that much money, nor what it would take to pay it back.  Fortunately, for those who borrowed from the federal government through the Direct Loan Program or the Federal Family Education Loan (FFEL) Program, rather than through private (bank) loans,  numerous flexible and alternative repayment plans are available.

               The federal government, through the Department of Education, offers what can appear to be a bewildering array of repayment options.  Depending upon (1) the type of loan, (2) the amount borrowed, (3) when the funds were disbursed, and (4) your family size and “discretionary income,” up to 7 alternative repayment plans are available in addition to the Standard Repayment Plan (fixed payments made over 10 years, as in the example above).  Moreover, an eighth alternative option, known as REPAYE (for “Revised Pay As You Earn”), is being rolled out in December 2015.

               Direct Loan and FFEL Program Loan repayment plans generally take one of 5 forms:

  • The Standard Repayment Plan—fixed monthly payments of at least $50 per month for 10 years.

  • Extending the loan term (called “Extended Repayment Plan”)—making the fixed monthly loan payments smaller by stretching out the loan period from 10 years up to 25 years.

  • Gradually increasing the payment amount (called “Graduated Repayment Plan”)—payments start out smaller than the standard payment and usually increase every two years, along with (presumably) your income.

  •  A combination of Extended and Graduated—both extending the loan term and gradually increasing the payments.

  •  Loan payments that are tied to your income, loan amount, family size, and state of residence—4 different plans of this type currently exist , with a fifth (REPAYE) being added in December. 

Note that, under repayment plans based on your income, if you don’t make a lot of money, you may not ever repay the total amount borrowed plus accrued interest.  If that occurs, under most of the income-based repayment plans, any unpaid loan balance at the end of the loan period is forgiven, although you’ll generally have to pay tax on the amount that’s forgiven. (Under the tax code, forgiven loan amounts are treated as income.)

Loan Forgiveness, Cancellation, and Discharge Options

               Student borrowers who enroll in an income-based repayment plan as described just above have the opportunity to earn tax-free loan forgiveness in as little as 10 years under what’s known as the Public Service Loan Forgiveness Program.   Generally, borrowers must make 120 on-time payments while working full-time for a federal, state, or local government agency such as public schools, or for public as well as private not-for-profit organizations. 

               Other loan forgiveness and cancellation options include Teacher Loan Forgiveness, the National Health Service Corps Loan Repayment Program, and various state education loan repayment programs.   Options involving loan forgiveness, cancellation, or discharge are also sometimes available for such things as closed schools, total and permanent disability, death, and (rarely) bankruptcy.

In short, the menu of options and choices can seem overwhelming.

Pros and Cons of the Loan Repayment Options

Keep in mind that you are not locked in to any one choice:  you can change your repayment plan at any time

The Standard Repayment Plan (Default Option)

Students are automatically placed into the Standard Repayment Plan (10 years of fixed, level payments). If you can’t afford the standard payments initially, and want to avoid this option, you must choose a different plan.

Pros:

  • This pays back the loan in the shortest period of time with the least amount of total interest.  You get rid of your student debt while you’re relatively young.  If you can afford this option, it’s an excellent choice.

Cons:  

  • The monthly payments may simply be more than you can afford.

Public Service Loan Forgiveness

               Pros:

  • In general, you can repay the absolute least amount and over the shortest time by choosing Public Service Loan Forgiveness and enrolling in one of the income-based repayment plans.

  • Affordable monthly payments.

  • After 120 on-time payments (which don’t have to be consecutive), any loan principal and accrued interest is forgiven, tax-free.  You won’t find a better deal than that.

               Cons: 

  • Achieving loan forgiveness under the program requires at least 10 years (120 months) of public service employment.  If that’s not part of your career plan, this option may not make sense.

  • While you’re making the 120 payments, the total amount outstanding on your loan is likely to grow (this is known as negative amortization), since income-based repayments often won’t cover the monthly interest due, which gets added to your loan balance.

  • Note:  the REPAYE Plan taking effect in December 2015 provides a new interest subsidy benefit intended to prevent such ballooning loan balances.

  • If you’re looking to buy a house or an apartment while paying back the loan, lenders may be reluctant to give you a mortgage while you’re carrying a large amount of student debt.

Income-based Repayment Plans

               Pros:

  • Payments are affordable (often capped at 10 to 15% of your discretionary income).

  • Under most of these plans, any outstanding balance after 20 or 25 years is forgiven.

               Cons:

  • You’ll be carrying the debt for up to 20 - 25 years.

  • You generally have to certify your income and family size annually.

  • Unless you’re enrolled in Public Service Loan Forgiveness or a similar program, the debt forgiveness is taxable to you.

  • As noted above, having a large debt-to-income ratio may make it difficult to obtain a mortgage down the line.

Extended and Graduated Repayment Plans

               Pros:

  • Monthly payments are smaller

  • Payments cover at least the interest that’s accruing, and generally some principal as well, so the debt is gradually reduced. 

               Cons:

  • You’ll pay more in total interest than under the standard 10-year repayment plan.

  • In some cases, such as the 10-year graduated repayment plan, the payments in later years will be higher than those under the standard 10-year plan.

  • With all extended plans, it will take longer to repay your debt, with the same disadvantages noted above for income-based repayment plans.

How to Choose a Plan That’s Right for You

First, Find Out What Your Monthly Payment Options Are

               Your loan servicer’s web site will usually lay out the repayment options available for your specific loans and the monthly payments each would require, and you will need to work with your loan servicer to enroll in any of the non-standard repayment plans.  Loan servicers may not always be proactive, however, in helping you to find a suitable plan.

For an excellent overview of your options, visit the Department of Education’s Federal Student Aid Website, click on “How to Repay Your Loans,” and then on  "Understanding Repayment."  From that page, click through to "Repayment Plans" and then check out the "Repayment Estimator" to get an idea of what your payments will be under various options.

Next, Choose the Plan That Best Fits Your Goals, Your Needs, and Your Budget

               Now that you have some idea of your monthly payment options, you’ll need to balance those against many other considerations.  The challenge is to thread the needle among all the important and competing life priorities in a way that gives you the optimal path for:

  • Paying off your student debt while minimizing interest costs

  • Getting an early start on retirement savings with Roth IRAs or 401(k) plans, especially those that offer an employer matching contribution

  • Paying for health insurance (remember that you can stay on your parents’ plan until age 26)

  • Building up an emergency fund

  • Funding other savings goals, such as a vacation, a car, or a house

  • Paying for everything else

In most cases, the most effective means of doing all this is to create a simple monthly budget and then to plug in the highest student loan repayment option you can afford after covering the essentials (rent, food, utilities, transportation, emergency fund).  The goal is to pay off the loan in the shortest amount of time with the least amount of interest.

On the other hand, if you’re committed to the Public Service Loan Forgiveness route, you can plan on making minimal payments under an income-related program such as REPAYE for 120 months while putting more money toward your other goals.

Recall that that you can switch repayment plans at any time, so you may want to start out with a graduated and/or an extended repayment plan with more affordable payments for the first few years.  After all, you probably want to leave at least some room in your budget for discretionary (i.e., fun) stuff, too.  You’ve earned it.

Make Your Payments on Time

        One benefit of making timely student loan payments is that you’ll establish a good credit history, which can help enormously when you’re renting an apartment, buying a car or a house, or simply applying for a credit card.  On the downside, not making timely student loan payments can tarnish your credit history and make life more difficult.

And Don’t Forget the Tax Benefits

One final note:  student loan interest of up to $2,500 per year is a deduction from gross income on your tax return, whether or not you itemize your deductions.  Depending on your income and your tax bracket, the deduction could save you between $250 and $625 each year. 

               Feel free to contact McGovern Financial Advisors for additional help or information.