A mortgage loan, a car loan, and credit card debt are all obligations that young people traditionally encounter as they start their new careers after earning a college degree. Now, more than ever, young people are having to manage another form of debt—student loans. The numbers are staggering: there are over $1.5 trillion in outstanding student loans nationwide, nearly 70% of students graduate with debt, and the average student loan balance is over $30,000. Given these balances, it is not surprising that 25% of borrowers are delinquent on their payments or are in default. Young people bear the stress of student loans and often carry unpaid student loans well into their adult life. Even parents face unpaid obligations years after their child graduates. Over 60% of unpaid loans are the obligation of people over 30 years old. These loans become a financial burden that can inhibit people from buying a home or a car, and from saving and investing. The debt weighs on people’s ability to improve their quality of life and to prepare for retirement. If you are in this situation, what options do you have to make student loan repayment more manageable?
Before discussing student loan repayment, it is critical to understand how to avoid taking on unaffordable debt. The time to do this is when deciding on what college a student will attend. As discussed in a July 2018 blog, students and parents must do their financial homework prior to making a college commitment. Specifically, they must compare the cost of attendance at a particular college to the available financial resources, including savings, grants, and scholarships. It is important to realize that any shortfall will be funded using education loans, and only a reasonable amount of debt should be considered in determining if the school is affordable. It is incumbent on students and parents to resist the easy but unaffordable credit that is made all too available by the government and by private lenders. Committing to an unaffordable school is a sure way of creating a long-term financial burden.
If you are one of the many college graduates or parents with student loans, what repayment options do you have. First and foremost, it is important to understand the type of loans you have. Do you have federal loans, private loans, or both types? The majority of loans are federal loans issued by the Department of Education. Federal loans include Direct Subsidized/Unsubsidized loans, also known as Stafford loans, which are issued to students, and Direct PLUS loans, which are issued to parents. Private loans are issued by banks and commercial lenders. The type of loan you have will determine what options for repayment are available.
Federal loans have options and terms not always available under private loans. Federal loans will discharge the unpaid debt in the event of the borrower’s death. Federal loans offer deferment and forbearance terms which allow borrowers to postpone payments during certain situations, including periods of unemployment or financial hardship. whereas private loans tend to only offer forbearance. Deferment can be beneficial, as during a deferment the borrower will not be charged interest. Conversely, during forbearance, interest continues to accrue on unpaid balances including unpaid interest. Avoid forbearance at all costs as accruing interest on unpaid interest can create an unmanageable repayment situation. Borrowers who enter into forbearance find that their debt grows significantly, and the repayment of loan balances becomes very costly and even more difficult when repayment resumes.
Federal loans have repayment options which fall into two categories: balance-based plans and income-driven plans. Balance-based repayment plans provide for a typical level payment over the term of the loan, which may be from 10 to 30 years. But what if those level payments are not affordable given your monthly income? In that case, consider switching to an income-driven repayment plan, which bases monthly loan payments on your income and family size, may be an option to consider. The plans include an income-contingent repayment (ICR) plan, an income-based repayment (IBR) plan, a pay-as-you-earn (PAYE) plan, and a revised pay-as-you-earn (REPAYE) plan. These plans use your income to determine an affordable loan payment that usually results in a lower payment. After making the monthly payment consistently for 20 to 25 years, the loan balance may be forgiven. Keep in mind, however, that the amount forgiven will be taxable income.
Another feature of federal loans is that they provide loan forgiveness for those people who pursue a government or non-profit public service job. The public service loan forgiveness program was established in 2007. Under this program, borrowers with Direct federal loans enter into a repayment plan over 10 years. The borrower must make timely and consistent loan payments, and at the end of the 10-year period the outstanding balance is forgiven. A favorable element of this program is that the forgiven balance is not taxable income. However, as a precaution, be sure to research and understand all of the program requirements to ensure you are eligible. Make sure you have the right type of loans, make sure you work for the right employer, and confirm you are on track throughout the repayment period. Many borrowers have made payments for a number of years only to find out that the repayment plan or the employer they have disqualifies them from debt forgiveness. Also, keep in mind that if you refinance a federal loan by converting to a private loan, you will no longer qualify for the loan forgiveness program.
Refinancing is a strategy to consider to lower interest rates or to make monthly payments more affordable. For federal loans, refinancing can take the form of loan consolidation. Federal loan consolidation combines existing loans by averaging the interest rates of the current loans and adding 1/8%. The repayment period can be lengthened, and all favorable benefits and terms of federal loans are kept.
An option for both federal and private loans is to refinance the loans with a single private lender. Under a refinancing, a new loan is entered into and the existing loans are paid off. The key benefit of refinancing with a private lender is that a borrower can get a lower interest rate. The downside is that benefits and favorable terms of the original federal loans are lost, including the various repayment options and the public service loan forgiveness program. Refinancing will also require you to have good credit or a credit-qualified cosigner.
How do you evaluate the various repayment and refinancing options to determine what is best for you? First, identify your goal. Is it to lower your interest rate, is it to pay off your loans faster, is it to pay less over the life of the loans, or is it simply to consolidate your loans into one payment? Second, know what type of loans you have and the repayment options they offer. If you consider refinancing, know your credit quality, identify a cosigner if necessary, and evaluate the importance of any federal loan benefits or terms that may be lost. Most important, understand the interest rate that you will be offered given your personal financial situation, as well as any fees that you will be charged, and determine the interest cost savings that you will realize by refinancing.
Federal student loans are regulated by Congress and every few years modifications are made to the terms of the program. Currently, Congress is proposing changes under the PROSPER Act. The proposed changes include eliminating the public service loan forgiveness program for new borrowers starting in 2018 and removing the federal repayment options and replacing them with only two repayment plans. The repayment plans would be less favorable and consist of a 10-year standard plan and the current income-based repayment (IBR) plan, which requires monthly loan payments based upon a 15% of discretionary income. More should be known about this new legislation later this year or early in 2019.
Student loans can prove to be a significant burden to both students starting their careers and parents looking to save and invest for their retirement. The best step a student and parents can initially take is to evaluate the cost of attendance for a school to ensure they sign up for only a reasonable amount of student loans. As the time comes to make loan repayments, spend the time to research all options to achieve the goal of lowering interest costs and establishing a monthly payment that can consistently be made over the duration of the loan. If you have questions on student loan repayment plans or need assistance in evaluating your options, please feel free to contact Bill or me for assistance.