By Drew Hefflefinger
Consolidation, income-driven repayment and private refinancing are three student loan repayment strategies. By understanding their pros and cons, the borrower is better able to make an educated and informed decision tailored to their financial circumstances.
At its base, a standard federal student loan is issued as a 10-year term, paid in equal monthly payments with the first payment due six months after graduation — all very cookie-cutter in theory. But you are not cookie-cutter material; you are unique. Law graduates land in a variety of places, including private practice, government, in-house, nonprofit, solo firms or are still trying to figure it all out. Whatever the situation, the typical 10-year schedule may not be the best repayment strategy given the immediate financial circumstances of the borrower.
Here are three common strategies borrowers consider when repaying student loans:
Consolidation is a strategy specific to federally issued loans where the borrower is allowed a one-time “refinance.” This option is typically selected because the borrower cannot meet the repayment requirements of the ten-year schedule. Consolidation does not increase or decrease the borrower’s interest rate, but allows the borrower to take the 10-year schedule and extend it up to 30 years.
This has an immediate pro and long-term con. Lower monthly payments can help tremendously with immediate cash flow; however, it also means paying the loan for a longer period of time and paying much more in interest. Figure A below shows the effects of a $150,000 principal on a 10, 15, 20, 25 and 30-year schedule at 6.00% interest. The column on the far right shares the additional paid interest of extending the term. This can be interpreted as the “cost of refinancing.”
What we see is a powerful effect where the borrower could potentially pay more in interest than in principal over the life of the loan ($150,000 principal vs. $173,754.82 total paid interest). Extending the schedule may feel good today, and may be required given the circumstances, but additional paid interest will start to have an effect on other goals, such as the down payment on a home, sending children to college and any retirement aspirations.
Income-Driven Repayment is another strategy specific to federal loans where monthly payments are based on a formula taking into account income and family size. Depending on when the borrower took out their first loan they pay either 10 or 15 percent of their discretionary income based on a government provided formula. Like the consolidation strategy, the borrower’s interest rate does not change and is a weighted average of existing rates. Especially early in one’s career, this strategy can reduce monthly payments significantly.
The consequences, however, are two-fold. Of most importance, the program’s term is 20 or 25 years. This is a long time, and similar to the table above, can significantly increase additional paid interest. Second, if there is a balance at the end of the 20 or 25 year schedule, then the balance is considered forgiven, and forgiven debt, in this instance, is included in gross income and taxable at ordinary income tax rates. Yes, you can go from owing the Department of Education to owing the Internal Revenue Service, a much more uncomfortable bed to sleep in. To compound matters, the projected loan balance could be higher than your balance today due to negative amortization, or “paying interest on interest.”
Nevertheless, if a borrower has high debt and relatively low income this may be the only option to stay current. Due to the recent rise in tuition costs, this has become a popular strategy among many law school graduates in the early stages of their career. Although this may be the only solution today, repayment strategy should be reassessed on an annual basis or as income rises in an effort to reduce total paid interest and avoid a potential tax bomb.
Private Refinancing is where the borrower approaches private lenders like a bank or lending institution with the goal of getting a lower interest rate. In many cases the borrower can save tens of thousands of dollars in total paid interest by just getting a lower rate! This is why people refinance their homes when rates are low, so why not refinance your “condo-sized” loans? Figure Bshares the same loan as before only at different interest rates and fixed on a ten-year schedule.
If debt is already private then you are already in this scenario; however, private refinancing of federal loans should not be taken lightly. The big risk is losing all of the unique benefits associated with federal loans, including the 270-day window for missed payments, forbearance, access to federal repayment programs, etc. Losing these benefits could lead to disaster to the lawyer just starting out or uneasy about job security. But if the borrower is at a strong firm, with stable income and emergency savings, this strategy warrants consideration.
So what should the borrower do? First, they should have a clear understanding of their own financial circumstances before making any decisions. These decisions are going to change the terms of repayment forever. Second, it is important to carefully consider all options before moving forward with a particular strategy; we always want to make educated and informed decisions. Third, these are complex decisions, and if time, patience, or expertise are lacking, seek a student loan expert (cough, cough) who can serve as your guide.
Drew Hefflefinger is a CERTIFIED FINANCIAL PLANNER™ at Engage in Wealth in Denver, Colorado. He specializes in working with attorneys by helping them protect and grow wealth while achieving life goals. He can be reached at email@example.com.