A Comprehensive Guide to Paying Off Your Student Loans
By Joe Messinger, CFP®
January 17, 2020
In today’s world, the existence of student loans is more common than ever. With 45 million borrowers, the chances are good that most college graduates will have some amount of loan debt. We are finding that student loan debt is preventing people from other life choices like buying a home, getting married, having children, or saving for retirement. So after you leave college, what happens next? What are some smart ways to manage and pay off this debt burden?
Is paying off students loans early a good idea?
Maybe. You will save thousands of dollars in interest. Once the loans are gone, not living with the month-to-month debt obligation increases your cash flow for other things. Having a lower debt-to-income ratio makes it easier to get a loan for a house, make other purchases, or build your wealth and save for retirement. If you are a worrier (and even if you’re not), having lower (or no) debt can be good for your health. The financial burden of debt is stressful for most people. Living debt free can be extremely liberating.
Are there drawbacks to paying off loans early?
You lose the tax deduction on student loan interest you might receive. In 2020, the IRS allows for taxpayers to claim up to $2,500 in paid student loan interest payments on federal taxes. Both federal and private student loans qualify for this deduction.
Each person should strive to have an emergency fund of money set aside. A good starting target for the fund is enough money to cover three months of expenses. Paying off your student loan early can prevent saving for emergencies.
Finally, student loan interest rates are usually pretty low compared to other forms of debt. If you are straddled with credit cards or car loans, paying off these debts first makes better financial sense. Pay the minimum amount due on your lower interest rate loans and apply any “extra payment” you can work into your budget towards the highest interest loan until it is paid off. Then repeat this process to eliminate the next highest interest rate obligation, and so on.
How to make the final decision about paying off your loan early?
The final decision of whether or not to pay off your student loan debt early depends on your financial situation.
- Do you have money saved for emergencies?
- Are you saving at least up to the company match in your work retirement plan?
- Have you paid off any higher interest debt like credit cards?
- What are your long-term financial goals?
- Is the interest rate on your loan higher than the potential rate you could be earning on that money if you invested it?
- Would you be happier knowing that your debt is paid off even if that money could be earning slightly more for you invested?
If you decide to pay off your loans early, contact your loan servicer to find out how they handle extra student loan payments. Will they apply it to the balance? Make sure they are applying any extra payments to the principal. You can set up automatic payments at a higher amount and not have to think about it each month. Alternatively, you could make payments every two weeks instead of once a month. Since interest accrues on a daily basis, make payments at the beginning of the month to shave a bit off the principal.
Tackling those student loan payments
If you skimmed through that first section and thought “pay off early?! I’m just trying to get by!”, don’t worry. You are not alone. You are the majority. What can be done?
You have to face this challenge head on and accept responsibility. Paying off debt is challenging but not impossible. Create a budget and live within your means. Find creative ways to reduce your expenses like making your own coffee at home, packing your lunch, taking the bus instead of an Uber. A lot of little things can add up. Check out our budget worksheet you can use. A great free online tool for budgeting and staying up to date on your spending is Mint.com.
Exploring the various repayment options
If you haven’t already, take the time to explore the variety of repayment options. Besides the Standard Repayment Plan, Federal Direct Stafford Loans have several different repayment options to reduce your monthly payment. But proceed with caution; the longer you stretch out your payments, the more interest you will have to pay over the life of the loan. You can choose:
- a graduated payment plan to lower payments at first and increase them gradually every 2 years
- an extended repayment plan to stretch the payments out evenly over 25 years
- a variety of income based (IBR) and pay as you earn repayment plans.
The Standard Repayment Plan
All borrowers of an eligible federal student loan are automatically enrolled in the Standard Repayment Plan if no other plan is selected. The repayment terms is 10 years. 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 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.
The Extended Repayment Plan
All borrowers of an eligible federal student loan are eligible for this plan. The balance due on your loan must be more than $30,000. 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
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) – The REPAYE plan is a repayment plan with monthly payments that are generally equal to 10% of your discretionary income, divided by 12. Monthly payment amount is based on adjusted gross income, family size and total eligible federal student loan balance. REPAYE payments are spread over 25 years.
- Pay As You Earn Repayment Plan (PAYE Plan) – The PAYE plan is the same concept as REPAYE except you must show you can’t afford to make the payments under a standard plan. Under REPAYE, you don’t have to show financial distress. PAYE payments are spread over 20 years.
- Income-Based Repayment Plan (IBR Plan) – The IBR plan is a repayment plan with monthly payments that are generally equal to 15% (10% if you are a new borrower) of your discretionary income, divided by 12. IBR payments are spread over 25 years.
- Income-Contingent Repayment Plan (ICR Plan) – The ICR plan is a repayment plan with monthly payments that are the lesser of (1) what you would pay on a repayment plan with a fixed monthly payment over 12 years, adjusted based on your income or (2) 20% of your discretionary income divided by 12.
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.”
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.
What about private loans?
If private student loan debt is your problem, explore consolidating your loans to get more favorable interest rates and more manageable lower monthly payments. Check out websites like sofi.com and simpletuition.com, as well as a number of credit unions who may offer better terms to consider. I encourage you to work with your current lender as well as other institutions to get the most favorable terms.
CAUTION: Companies out there will make claims they can wipe out your debt if you pay them a fee. DO NOT fall victim to deals that sound too good to be true. If it sounds too good to be true, it probably is!
What happens when you fall behind?
In some cases of hardship, loan payments are being missed, and borrowers need to look at all their options. To understand your options, we must explore the terms: deferment, forbearance, loan cancellation, loan default, and loan rehabilitation.
Deferment is a postponement of your payments on the loan.
This postponement is the right of the loan holder under certain conditions. During this period, interest does NOT accrue for Direct Subsidized Loans, Subsidized Federal Stafford Loans, and Federal Perkins Loans. The government pays the interest for you. Deferment can last up to six months and sometimes longer. For some situations, certain lenders will allow you to recertify your deferment every year for up to three years. If you have a different type of federal loan (Unsubsidized), then the interest DOES accrue and is added to your principal balance. If your interest is accruing, you can choose to make payments on the interest only.
Because deferment is a right of the loan holder, the lender does not have the option to deny it. The conditions that make you eligible for a deferment are:
- Enrolled at least half time in a postsecondary school or are in graduate school
- Participation in the Peace Corps Service, active duty, National Guard or other reserve (called to active duty)
If you are not eligible for a deferment, you can apply for a forbearance.
Forbearance is a period of time up to 12 months when your loan payments are temporarily suspended or reduced and is granted by the lender. Certain types of financial hardships can trigger forbearance. You want to make your payments, but you are simply unable to do so. Payments are postponed and interest does accrue. When interest is accruing, it is added to your total loan amount. If you want to keep the principal from increasing, you must make interest payments. Variable interest rates will remain variable.
Unlike deferment which is a right, forbearance is not and must be approved. Even if you fall within the following circumstances, you might not be approved for forbearance. The circumstances when you can try to have your loan reduced or suspended are:
- Teachers in a teacher shortage area
- Unusual life circumstances
- Financial hardship (incl. exhausting your unemployment deferment)
- Loan repayment history is good
- Poor health
- Medical/dental internship residency
- Governmental volunteer service (like AmeriCorps)
In both deferment and forbearance situations, you must apply to the lender to be approved. There’s always paperwork, right? Be sure to keep careful records and continue with payments if you can.
What happens when deferment, forbearance, and cancellation will not work, and you can’t make your payments?
You may face loan default. The first day you miss a payment your loan becomes delinquent. After 90 days of delinquency, loan servicers will report the delinquency to one of the three major credit reporting agencies. Your credit history will now be impacted. A negative credit history affects your ability to buy a car, rent an apartment, buy insurance, or even get a cellphone plan.
After 270 days of delinquency, your loan goes into default. The impact of default is severe. The entire loan amount including interest becomes due and payable in full. Plus, the amount due will increase because of late fees, collection fees, attorney’s fees, and other costs which quickly escalates the amount due. In certain cases, the fees may end up exceeding the original amount due.
In addition, you will/may:
- Lose eligibility for deferment, forbearance, or repayment plans
- Lose eligibility for future federal student aid
- Have your loan assigned to a collection agency
- Forfeit any federal or state tax refund to be applied to the outstanding balance
- Suffer wage garnishment from your employer (Federal employees face Federal Salary Offset.)
- The lenders may take legal action against you and prevent your buying or selling of real estate.
- You will face years of trying to rebuild your credit and recover from default.
Is there any way to recover from default? Yes. The most obvious is to repay the loan amount in full. Probably not very practical when you are struggling financially.
Another option is loan rehabilitation.
Under Direct and FFEL Program loans, you agree to make payments equal to at least 15% of your discretionary income. Payments may be as low as $5 per month depending on your income. Wage garnishment does not count as payments made by you. You also agree to make nine monthly payments within twenty days of the due date within a period of ten consecutive months. If you fulfill those requirements, your loan will no longer be considered in default. It will be rehabilitated.
Under Perkins loans, your monthly payment is determined by the school holding your loan. You must make full payments every month within twenty days of the due date for nine consecutive months.
You can only rehabilitate a loan once. But once you do, you will regain access to deferment, forbearance, repayment, and forgiveness if applicable. The default will be removed from your credit history but not the late payments from before the loan defaulted.
Can your debt ever be forgiven?
Loan forgiveness, cancellation, and discharge are three terms that mean almost the same thing, but not quite. The federal government uses the term forgiveness or cancellation to refer to situations where borrowers are no longer required to make payments on their loan due to the job they hold. If the borrower is no longer required to make payments on a loan because of a certain situation like a disability, the government uses the term discharge.
Loan discharge can take place in these situations:
- total and permanent disability
- closed school
- program false certification of student eligibility (the school approved you for the loan when they shouldn’t)
- unauthorized signature/unauthorized payment (like in cases of identity theft or the school signed the paperwork on your behalf)
- unpaid refund (you withdrew from school, but the school didn’t pay back the loan to the government)
- bankruptcy BUT only in extremely rare cases
The federal government has only two programs for loan forgiveness:
- Teacher Loan Forgiveness Program (TLFP)
- Public Service Loan Forgiveness (PSLF)
The Teacher Loan Forgiveness Program (TLFP)
The TLFP was created by Congress. In general terms, the program requires you to teach for five consecutive, complete years at an eligible/low-income school, and your loan must have started before the end of your fifth year of teaching service. Teachers cannot obtain loan forgiveness on loans in default. You must first arrange repayment. You cannot obtain benefits under TLFP and AmeriCorps or Public Service Loan Forgiveness Program. The years of service for TLFP cannot be used for these other programs. Special education teachers are included for forgiveness program. Teacher aides are not. You cannot be repaid for loan payments you have already made. Only outstanding balances and accrued interest are eligible for repayment.
So how much of your loan can be forgiven? Up to $5,000 payment towards outstanding principal and accrued interest. In certain situations, you can qualify for a higher forgiveness amount. You may qualify for an additional $12,500 ($17,500 total) if you meet the “highly qualified” standard AND been either a math or science teacher OR a special education teacher.
Public Service Loan Forgiveness (PSLF)
The PSLF is available to employees of the government (federal, state, local, or tribal) as well as most non-profit organizations (tax exempt/not-for-profit 501(c)(3) and not tax exempt/not-for-profit in certain qualifying services like emergency management, public libraries, public health, etc.).
Under the PSLF, the federal Direct Loan is forgiven after 120 qualifying loan payments have been made under a qualifying repayment plan for anyone working full-time for a qualifying employer.
For PSLF to be approved, the borrower must be making payments in an income-driven repayment plan (like we talked about above) in order to qualify. Making regular/standard payments on a loan will not count towards the 120 magic number. The payments must be made as a part of an income-driven plan. If this seems confusing, consider this. Before the government will forgive your loan, 120 monthly payments need to be made. 120 payments equals ten years. Typical loan repayment would be done in ten years, and you would have nothing left to repay. Using an income-driven plan, extends the term and allows for some remaining balance to be forgiven.
The world of student loan debt can be confusing.
The key is understanding all your options. Be sure to stay organized. Know who your lenders are and how to get in touch with them. Stay on top of balances, payments, due dates, etc. Stick to a budget. Evaluate all the payment options–pay ahead when you can, investigate repayment options. Most of all–don’t panic! Many, many people are in your shoes. Just take it one step at a time.
May 29, 2020