How to pay off your student debt & how student loan forgiveness works.
As another school year comes to an end, chances are you are affected by student debt either as a parent or student. There is currently more than $1.3 trillion1 in outstanding student debt in the United States, affecting more than 40 million households2 with 70% of all students graduating with some debt3. It’s thought this amount may be more than the rest of the world combined!
One of the most asked questions we receive is how to pay back the amount you borrowed for education. It’s important to understand your repayment options and which one is right for your situation. Depending on the type of loan you hold and the career you enter the options can vary and become quite confusing. For the scope of this post we’ll stick with Federal Loans which are issued by the US Department of Education, these are Direct Loans including subsidized and unsubsidized, Perkins Loans, and Stafford Loans. Private loans differ, however the same pay down concepts can be applied.
Standard Repayment Plan
The standard federal repayment plan requires a minimum of $50 per month and repay period of up to 10 years. If you’ve consolidated your loans you may be eligible for a repayment period of up to 25 years. However, getting rid of your loans mean paying more than the minimum payment due each month, the more you pay the faster it goes.
As with any savings strategy we recommend separating fixed expenses from your financial priorities and discretionary income. This will give you a clear picture of how much income you are working with for your goals and lifestyle decisions. From there you can make choices on how much to allocate to your specific goals.
- Always get your match. Make sure you contribute to your company sponsored retirement plan the amount necessary to receive the maximum matching contribution. Don’t give away free money/additional compensation.
- All in or Balanced. After taking out your necessary company plan contribution determine your desired payback period. (i.e. ASAP, 3 years, 5 years) and crunch the numbers to get it done. Some want this debt gone as soon as possible and others will want to balance saving for other goals simultaneously. While this decision really hinges on preference and how you feel about debt, there are some numbers to consider. What are the applicable interest rates on your loans? What other savings needs and goals do you have? Our preference varies by case-by-case but we are huge fans of eliminating this debt as soon as possible, and in general favor paying down debt vs allocating money to investments. In some cases, major purchase goals can run concurrent.
- The rule of 20. Our rule of thumb is for 20% of your net income to be allocated toward your financial priorities. If serious about paying down your loans use additional money allocated toward discretionary expenses for the purpose of paying down your debt and funding additional priorities.
- Make sacrifices. Lifestyle choices are the key to getting ahead of the debt, we need to prioritize what is really important. Do you really need that new car or would you like to have your loans paid off 5 years early? Is it possible to allocate 30% of your income to priorities rather than 20%?
Your payback strategy will depend on your ability to earn income, if you are a high earner it will likely make sense to use the standard repayment plan and accelerate your pay down by making additional payments. Remember to pick your targeted pay off date and crunch the numbers to make it happen.
Student Loan Forgiveness
There are currently two types of loan forgiveness programs being offered by the Federal Government. The Public Service Loan Forgiveness (PSLF) program and 4 differing Income Based Repayment Plans (ICR, IBR, PAYE, REPAYE). There are criteria you must meet to qualify for each of the programs with the exception of REPAYE.
With PSLF you must work full time at a qualifying public service organization, this includes non-profits & government organizations. After a period of ten years or 120 on-time monthly payments your remaining loan balance will be forgiven. The payments don’t have to be consecutive (meaning you can bounce between profit and non-profit work) and payments can also be calculated as income driven. The best part, you won’t be taxed on the forgiven balance. In our opinion this program can have some real value.
In contrast, in order to quality for Income Based Repayment plans you must show you can’t afford your bill on the standard repayment plan, with the exception of REPAYE where anyone with federal loans can apply. Each plan is different, however your payment is calculated as a % of income (generally 10%) and is based on a 20 or 25 year repayment period. Check out the repayment estimator for details and estimates related to your unique situation. At the end of the repayment period any outstanding balance will be forgiven, although you will be taxed on the amount forgiven, which could be a substantial amount.
If you aren’t currently a high earner or expecting to become one in the future, Federal loan forgiveness programs may give you relief in the form of lower payments stretched over a longer period of time thus freeing up cash flow. However, with Income Based Repayment plans you will pay more interest over time and you could potentially have a significant tax bill on the amount forgiven. To this point we question the income based plan options being labeled as forgiveness. While providing a longer payment period and lower payment amounts, the total cost of the loan tends to be significantly higher. In addition the principal amount forgiven at the end is taxable. Use the repayment estimator for an illustration. A true forgiveness program would relieve the burden of the interest rate as well as the outstanding principal balance without major tax liability.
We know this is a sensitive issue for many and an important issue in our nation, as it continues to evolve we’ll keep you updated on any changes. Call or email us so that we can help you plan and maximize your payments. As always if you have any questions, please don’t hesitate to contact us!
1 Federal Reserve
3 White House
*The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations to any individual. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor