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 students 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. Students will save thousands of dollars in interest. Once the loans are gone, not living with the month-to-month debt obligation increases their 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 wealth and save for retirement. Worriers, having lower (or no) debt can be good for their 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?
Students can lose the tax deduction on student loan interest they 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 student loans early can prevent saving for emergencies.
Finally, student loan interest rates are usually pretty low compared to other forms of debt. If a person is straddled with credit cards or car loans, paying off these debts first makes better financial sense. Pay the minimum amount due on the lower interest rate loans and apply any “extra payment” into the 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 student loan debt early depends on each person’s financial situation.
- Do they have money saved for emergencies?
- Are you saving at least up to the company match in the work retirement plan?
- Paid off any higher interest debt like credit cards?
- What are the long-term financial goals?
- Is the interest rate on loans higher than the potential rate that could be earning on that money if it was invested?
- Would people be happier knowing that their debt is paid off even if that money could be earning slightly more if it was invested?
If people decide to pay off their loans early, they should contact the 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. Automatic payments can be set up at a higher amount and then it does not have to be thought about each month. Alternatively, payments can be made 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 your clients are just trying to get by and paying off early is not an option, don’t worry. They are not alone, but are the majority. What can be done?
Each client has to face this challenge head on and accept responsibility. Paying off debt is challenging but not impossible. Create a budget and live within those means. Find creative ways to reduce expenses like making coffee at home, packing a lunch, or taking the bus instead of an Uber. A lot of little things can add up. Look for a budget worksheet that clients can use. A great free online tool for budgeting and staying up to date on spending is in Mint.com.
Exploring the various repayment options
If your clients haven’t already, tell them to 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 monthly payments. But proceed with caution; the longer the payments are stretched out, the more interest is payed over the life of the loan. The choices are:
- 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. The 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, the higher the monthly payments will be.
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 payments start low and increase every two years. Under this plan, your clients will 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 the 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, your client will pay more for their loan over time.
Income Based Repayment Plans
Plans based on income also exist, and depending on your client’s income, the monthly payment may be as low as $0. Income-based repayment plans have been expanded significantly just in the last few years. If your clients have not explored this option recently it may be worth another look.
They are based on discretionary income and allow your client to pay based what they 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 your clients must show they can’t afford to make the payments under a standard plan. Under REPAYE, they 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 your clients are a new borrower) of their 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 your clients would pay on a repayment plan with a fixed monthly payment over 12 years, adjusted based on their income or (2) 20% of their discretionary income divided by 12.
When calculating the monthly payment for the income-based plans, your clients have to look at their 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.”
Your clients need to be aware that every year, their monthly payment is adjusted and it will require them to file paperwork. For PAYE, REPAYE, and IBR, the monthly payment is revised according to their updated income and any changes to family size. In addition, for ICR, the monthly payment is also affected by their total Direct Loan amount.
What about private loans?
If private student loan debt is your client’s problem, explore consolidating their 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 client and encourage them to reach out to their current lender as well as other institutions to get the most favorable terms.
CAUTION: Companies out there will make claims they can wipe out debt if they get paid 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 your clients fall behind?
In some cases of hardship, loan payments are being missed, and borrowers need to look at all their options. To understand these options, they must explore the terms: deferment, forbearance, loan cancellation, loan default, and loan rehabilitation.
Deferment is a postponement of 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 them. Deferment can last up to six months and sometimes longer. For some situations, certain lenders will allow people to recertify their deferment every year for up to three years. If your clients have a different type of federal loan (Unsubsidized), then the interest DOES accrue and is added to their principal balance. If the interest is accruing, your clients 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 your clients 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 your clients are not eligible for a deferment, they can apply for a forbearance.
Forbearance is a period of time up to 12 months when loan payments are temporarily suspended or reduced and is granted by the lender. Certain types of financial hardships can trigger forbearance. Your clients want to make their payments, but they are simply unable to do so. Payments are postponed and interest does accrue. When interest is accruing, it is added to the total loan amount. If your clients 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 your clients fall within the following circumstances, they might not be approved for forbearance. The circumstances when they can try to have their 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, your clients must apply to the lender to be approved. There’s always paperwork, right? Be sure to keep careful records and continue with payments if they can.
What happens when deferment, forbearance, and cancellation will not work, and your clients can’t make their payments?
Your clients may face loan default. The first day they miss a payment their loan becomes delinquent. After 90 days of delinquency, loan servicers will report the delinquency to one of the three major credit reporting agencies. Your client’s credit history will now be impacted. A negative credit history affects your client’s ability to buy a car, rent an apartment, buy insurance, or even get a cellphone plan.
After 270 days of delinquency, your client’s 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, your client’s 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.
- Your client’s will face years of trying to rebuild their 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 your client’s are struggling financially.
Another option is loan rehabilitation.
Under Direct and FFEL Program loans, your clients agree to make payments equal to at least 15% of their discretionary income. Payments may be as low as $5 per month depending on their income. Wage garnishment does not count as payments made by your client. They also agree to make nine monthly payments within twenty days of the due date within a period of ten consecutive months. If they fulfill those requirements, their loan will no longer be considered in default. It will be rehabilitated.
Under Perkins loans, the monthly payment is determined by the school holding the loan. Your client must make full payments every month within twenty days of the due date for nine consecutive months.
Your client can only rehabilitate a loan once. But once they do, they will regain access to deferment, forbearance, repayment, and forgiveness if applicable. The default will be removed from their credit history but not the late payments from before the loan defaulted.
Can your client’s 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 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 client’s behalf)
- unpaid refund (your client 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 students to teach for five consecutive, complete years at an eligible/low-income school, and their loan must have started before the end of their fifth year of teaching service. Teachers cannot obtain loan forgiveness on loans in default. They must first arrange repayment. They 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. They cannot be repaid for loan payments already made. Only outstanding balances and accrued interest are eligible for repayment.
So how much of your client’s loan can be forgiven? Up to $5,000 payment towards outstanding principal and accrued interest. In certain situations, they can qualify for a higher forgiveness amount. They may qualify for an additional $12,500 ($17,500 total) if they 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 client’s loan, 120 monthly payments need to be made. 120 payments equals ten years. Typical loan repayment would be done in ten years, and your client’s 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 to helping your clients understand all their options. Be sure they stay organized. Know who their 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 they can, investigate repayment options. Most of all tell them not to panic! Many, many people are in their shoes. They just take it one step at a time.