Are you trapped under something heavy (student loan debt)?

By Joe Messinger, CFP®

June 17, 2016

8 min READ

The numbers are staggering…

$1.3 trillion – total outstanding student loan debt in America

38 million – number of Americans with student loan debt

$37,172 – The amount the average college graduate (of the class of 2011) owed in college loans.

7 million – number of borrowers currently in default

Graduates under 35 are spending 1/5 of their salary on student loan payments and 60% of them expect to still be paying their loans off into their 40s.

Very sobering stuff. The reality is that for the vast majority of us, student loans are a necessary tool to pay for college. Our vision for our 3-step process is to reach every family so that every student graduates with manageable student loan debt but unfortunately for some that ship has sailed. Part of being a well-educated consumer of a college education includes understanding loan consolidation programs. Having this knowledge is important whether you are a graduate yourself burdened with debt OR a family creating a plan to pay for college for your future college student.

As you may know, student loans are divided into two general categories—federal and private loans. In this post, we’ll teach you about federal consolidation and repayment programs. (Need to know more about the types of federal loans available? Review our blog post here.)

Before we get too far along, maybe we better talk about whether or not you should consolidate multiple federal student loans into one. Is a Direct Consolidation Loan a good idea for you?

Pros:

• Can simplify your loans by combining them into one bill
• Can lower monthly payments because you’re stretching out the term of the loan up to 30 years (from the standard 10 year repayment schedule)
• Can access alternative plans you didn’t have before
• Can switch from a variable interest rate to a fixed interest rate

Cons:

• By stretching out the term of your loan, you will pay more in interest.
• Be careful to compare your current payment vs. your future payment.
• Be careful about losing the benefits of your current program like discounts, rebates, and cancellation terms.

When federal student loans are consolidated, you can change the term of repayment from 10 years up to 30 years. The new fixed interest rate will be the weighted average of your various interest rates, rounded up to the nearest one-eighth of 1%. You can consolidate loans after you have graduated, leave school, or drop below half time student status. No fees are charged to consolidate, and you can prepay without penalty. You can apply for a Direct Consolidation Loan on StudentLoans.gov.

Federal student loans and Direct Consolidated Loans have various repayment options, and one of them may make payment of your loans easier for you to handle. Repayment plans can be broken into traditional and income-based types. Let’s start with traditional repayment plans.

Traditional Repayment Plans

Standard Repayment Plan:  All borrowers of an eligible federal student loan are eligible for this plan and are automatically enrolled in it if no other plan is selected. The Standard Repayment plan term is 10 years; however, a Direct Consolidation loan term is based on the amount you owe. Your payment will be at least $50 per month. A standard plan is paid off quicker than the other plans with a lower total interest amount. Because of the shorter time frame, your monthly payments will be higher. The length of your Direct Consolidation loan is determined according to your amount of debt:

Graduated Repayment Plan:  All borrowers of an eligible federal student loan are eligible for this plan. The graduated plan allows up to 10 years to repay, and your payments start low and increase every two years. Under this plan, you’ll pay more in total than under the 10-year Standard Repayment plan. If choosing a Graduated Repayment for your Direct Consolidation loan, the repayment period will increase based on the amount of your loan according to the table in the Standard Repayment section.

Extended Repayment Plan:  All borrowers of an eligible federal student loan are eligible for this plan. In addition, to be eligible for this plan your student loan balance must have been $0 as of October 7, 1998, and your loan must have started after October 7, 1998. Also, the balance due on your loan must be more than $30,000. (Note if consolidating your Direct Loan and your Federal Family Education Loan, FFEL, the balance of each must be over $30,000. You can’t consolidate $30,000 of Direct Loans together with $10,000 of FFEL.) Payments may be fixed or graduated amounts with an extended term of 25 years. The monthly payment amount is determined based on how much needs to be paid to finish paying it off in 25 years. Generally, payments made under the Extended Repayment Plan will be less than the Standard or Graduated Plans detailed above; however, you will pay more for your loan over time.

Income-Based Repayment Plans

Besides the traditional repayment plans, plans based on your income also exist, and depending on your income your monthly payment may be as low as $0. Income-based repayment plans have been expanded significantly just in the last few years. If you have not explored this option recently it may be worth another look. They are based on your discretionary income and allow you to pay based what you can afford. There are four types (and as with all government programs they have their own acronyms): Revised Pay As You Earn Repayment Plan (REPAYE Plan), Pay As You Earn Repayment Plan (PAYE Plan), Income-Based Repayment Plan (IBR Plan), and Income-Contingent Repayment Plan (ICR Plan).

Monthly Payments – When calculating the monthly payment for the income-based plans, you have to look at your discretionary income in the calculation. Discretionary income is defined as “the difference between your income and 150 percent of the poverty guideline for your family size and state of residence.” This definition is used for the REPAYE, PAYE, and IBR plans. Just to make things difficult, the government uses a different definition for discretionary income for the ICR plan. In that case, it is “the difference between your income and 100 percent of the poverty guideline for your family size and state of residence.”

Let’s use an example. Say you were a single person with no spouse or dependents. Your family size would be one. You can see on the government’s poverty guideline table for a single person household, the poverty threshold is $11,880. 150% of that amount is $17,820. If you earned $35,000 annually, your discretionary income for the REPAYE, PAYE, and IBR plans would be $17,180 ($35,000 minus $17,820) or $1,431 per month. If looking at the ICR plan, your discretionary income is the difference between $35,000 and $11,880 or $23,120 ($1,927 per month).

Why does this matter? Under the PAYE and REPAYE plan, your monthly payment is 10% of your discretionary income or $143. Under the IBR plan, your payment is 10% or 15% of your discretionary income. The ICR plan uses the lesser of 20% of your discretionary income ($385) or the amount you would pay on a repayment plan with a fixed payment over 12 years.

This example is not to dissuade you from considering these programs, but you need to be aware that every year, your monthly payment is adjusted and it will require you to file paperwork. For PAYE, REPAYE, and IBR, the monthly payment is revised according to your updated income and any changes to your family size. In addition, for ICR, the monthly payment is also affected by your total Direct Loan amount.

The Effect of Marriage – Our calculations above were based on a single person household. Getting married can affect your income-based repayment plan. First, the change in household size will change the poverty threshold used in your discretionary income calculations. Second, sometimes your spouse’s income or loan debt will be included in the figuring as well.

Under the PAYE and IBR plans, a spouse’s income and loan debt will be added in only if you have filed a joint tax return. Like the PAYE and IBR, the ICR will only consider a spouse’s income and loan debt if you file taxes jointly; however, you can choose to include a spouse’s Direct Loan repayment and therefore their income and loan debt amounts. Under REPAYE, a spouse’s income and loan debt will be considered whether you file jointly or not. These considerations often come into play for young doctors that have incurred significant debt financing their education and are now getting married. Don’t assume that you will not qualify because you make too much money, especially if you have a spouse still in school or not working outside the home.

Loan Forgiveness – Under each plan, the maximum number of years you pay back a loan is capped to a certain number. Under the PAYE plan, any remaining loan balance will be forgiven after making payments for 20 years. If you haven’t repaid your loan in full under the REPAYE or IBR plans, any outstanding balance will be forgiven after 20 or 25 years. Finally, under ICR your loan is forgiven after 25 years. Be aware you may have to pay income tax on any unpaid loan balance for which you have been forgiven.

Take Note – Some income-based plans may require a higher monthly payment amount than the standard 10-year plan (REPAYE and ICR). PAYE and IBR monthly payments will never be higher than the 10-year standard payment. In all cases, you will pay more in total over time with the income-based plans. Generally, you want to take advantage of these plans when you have a high debt to income ratio. Also not all types of federal loans qualify for every type of income-based repayment plan. Refer to this table for the eligible loan types per repayment plan.

Application for income-based repayment plans are available here.

(If your student is planning on becoming a teacher, you may want to check out our blog about the teacher loan forgiveness program. Students and parents employed in certain public service fields may also consider the Public Service Loan Forgiveness Program.)

So what about Parent PLUS Loans?

As we’ve discussed, graduates have lots of options to refinance and consolidate their federal student loans. But what about parents? Parents who obtain Parent PLUS Loans also have some options available to them. All parent loans are 10-year standard repayment plans by default allowing you to pay less over time due to the shorter time frame; however, monthly payments may be higher and more difficult for you to afford. Graduated and Extended Repayment Plans are an option but may not be a good fit.

One good option is an Income-Contingent Parent PLUS Loan (ICR). The other income-based repayment plans are not available to parents. Your monthly payment will be 20% of your discretionary income and is spread over 25 years with any unpaid balance forgiven. To qualify for this plan, you must first consolidate your loan into a Direct Consolidation Loan.

One other option is refinancing your student loans or your Parent PLUS Loan through private banks and lenders.  Private student loans are not funded or subsidized by the federal government; instead, they are funded by banks, credit unions, or other types of lenders. In the last 5 years we have seen a number of private lending firms pop up that are specifically targeting student loan consolidation. Companies like Sofi, Earnest, and Credible to name a few. You very well may be able to find lower interest rates than the federal rate, but you have to qualify based on a good credit score.

A lower interest rate and life of loan savings that is touted by private lenders should not be your only consideration. You need to be aware of what you give up by going with a private loan as opposed to federal loans. Here are just a few:

• Federal student loans are generally fixed, not variable; most private student loans carry variable interest rates.
• Federal student loans have a variety of flexible repayment options that allow you to limit the amount you must repay each month based on your income as discussed in this article in detail.
• For borrowers pursuing public service careers, loan forgiveness on federal student loans may be available after 10 years.
• With federal loans you can delay payments through deferment or temporarily forgo payments through forbearance.
• LAST BUT NOT LEAST – Federal loans are discharged upon a borrower’s death or permanent disability (with limitations). Private lenders will get their money from someone even if you aren’t around!

When considering consolidation and various repayment plans, carefully weigh the pros and cons discussed. Perhaps a more careful look at your budget would be beneficial. Where can you make cuts? Also consider deferment or forbearance as options for short-term relief. If none of these options is a good fit for you, find a repayment plan that provides the best choice for your situation.

Families whose students haven’t gone off to college yet…we always recommend you know how you will pay for all four years of college down to the penny before you decide on where your student will go. Part of knowing how you will pay may include student loans in the plan. Remember that you should never take out more in student loans for your degree than you anticipate making your first year out in that field of study. Being familiar with repayment programs can give you the knowledge you need to make the decisions of an educated college consumer.