The debt clock started ticking this month for new graduates who financed college diplomas with student loans. Navigating the technicalities of loan repayment, however, can be tricky. Not only are today’s student loan balances daunting, but the process is confusing and the rules keep changing.
Even the professionals say it’s easy to get lost in repayment hell. Fee-only financial planner Mary Hoey, of Braver Wealth Management in Needham, says she has found it surprisingly difficult to get answers to even basic questions, such as how to get a 1098-E tax form to claim an interest deduction for her husband’ student loan. He still owes about $20,000 after making payments for eight years.
The average college student last year graduated with $27,200 in debt, but it’s not uncommon to hear about journalism students graduating with more than $100,000 in debt or social workers leaving graduate school owing $160,000. Medical school graduates can easily find their student debt topping $200,000.
So what’s the best way to tackle repayment?
“The first step is to take a complete inventory of your loans,” says Fred Amrein, a Philadelphia area fee-only financial adviser who specializes in college funding and financial aid. Start by separating federal loans from private loans, since they are governed by different rules. Then catalog each loan, noting the lender, the interest rate, and when payments are scheduled to begin.
Once you know what you owe, start reviewing options, which include:
Consolidation. Because penalties can be severe if you miss a payment, it often makes sense to reduce paperwork by combining loans. Consolidation will mean you deal with a single monthly payment rather than multiple lenders, each with a different set of rules.
What will your interest rate be? Consolidate your federal loans and you’ll end up with a weighted average of the interest rates. If you agree to have your monthly loan payments automatically deducted from a checking or savings account, you can knock an additional quarter percentage point off the interest rate. And borrowers with loans through both the now discontinued Federal Family Education Loan program and the current Direct Loan Program can save an additional quarter point on their FFEL debt if they consolidate into the Direct Loan program before June 30, Amrein says.
You cannot, however, consolidate private loans with federal loans. In addition, the options for private consolidation are more limited. But private student loans use adjustable rates based on credit scores, so you may be able to lower interest rates through consolidation if you or your cosigner have improved your credit scores since taking the loan.
Lengthening loan repayment. The standard repayment term on student loans is 10 years, but the resulting monthly payments can swamp the budgets of new graduates. Someone with a $35,000 annual salary and $45,000 in private and federal student loans, for example, would find loan payments consuming 25 percent of monthly take-home pay, leaving just $1,545 to cover housing, food, transportation, and other living expenses, says Amrein.
You can lower monthly payments by extending loan terms. With federal loans, students can stretch payments over 25 or 30 years, depending on the loan balance. Such extensions lower the monthly payment, but increase the total amount of interest paid.
Using Amrein's example — based on $33,000 of federal debt and $12,000 of private loans — stretching federal payments over 25 years would trim combined payments to $365 a month, from $517. But the amount of interest paid on the federal loans would nearly triple over the life of those loans, jumping to $32,613 compared with $11,563
Still, this approach can make sense, particularly if you make extra payments to reduce the principal whenever money becomes available, says Gary Carpenter, executive director of the National College Advocacy Group, a nonprofit organization in Syracuse, N.Y., specializing in college planning issues. But make sure to instruct lenders to apply those payments to principal. Carpenter suggests sending those payments by certified mail to “make sure you have something you can track in the future.”
Income-based repayment. Introduced in 2009, income-based repayment is an increasingly popular option. Available only on Direct Loan and Federal Family Education Loan programs, it reduces monthly payments to no more than 15 percent of discretionary income. The maximum repayment term is 25 years. Any loan balance remaining at that time is forgiven, although the discharged debt is taxed as income.
To encourage students to go into public service or nonprofit work, the federal government has made the income-based repayment program particularly attractive to graduates entering those fields. Forgiveness of the remaining balances is granted after just 10 years, and the discharged debt is not considered taxable income. This feature is only available to those making payments under the Direct Loan program.
In Amrein's example, using income-based repayment cut total monthly payments to 18 percent of take-home pay. For someone qualifying for forgiveness after 10 years, nearly $19,000 of the loan would be forgiven, so total principal and interest on the federal loans is reduced to $31,374 — less than the original amount borrowed.
Other options . Alternative methods include graduated repayment, which starts with lower payments that increase every two years. There’s also income-contingent repayment for those with direct loans and income-sensitive repayment for Federal Family Education Loans. Both adjust payments based on previous-year tax returns to reflect changes in the borrowers’ income
When picking a repayment strategy, factor in not only anticipated increases in income, but also the impact these loans will have on your ability to buy a car or home. Even getting married can affect repayment since family income is calculated differently in each program.
And finally, don’t forget that these loans can last a very long time. Carpenter of the National College Advocacy Group cites a 32-year-old doctoral candidate who graduated with $175,000 in debt. If he extends his loan repayments for 30 years, Carpenter says, “he could end up collecting Social Security before his student loans are paid off.”