|Trinity Newsletter: October 2016
Tip of the Month: For more information about student loan repayment options, see FinAid.org . Here you will find information on public and private student loans as well as references to other student loan sites.
Common Mistakes Borrowers Make with Student Loans
Total college-loan debt in the U.S. is more than five times what it was just 20 years ago. So the consequences of managing that debt have never been greater. As students struggle to repay record levels of student-loan debt, many are making costly mistakes that threaten to undermine their long-term financial security.
Roughly one in four borrowers falls behind on repayments or is in default, which can result in a host of negative consequences from damaged credit to garnished wages. After making their loan payments, many others are struggling to find enough money to save for retirement. Among 401(k) participants with student debt (in plans administered by Fidelity Investments), two-thirds say they have reduced or stopped their 401(k) contributions or have taken out a 401(k) loan or hardship withdrawal.
What follows are five student-loan mistakes borrowers commonly make and how you can avoid them.
MISTAKE NUMBER 1: Failing to Consider Income-Driven Repayment Plans
When it comes to government-backed student loans, many people stick with a Standard Repayment plan. Standard Repayment is the default option that requires the borrower to make fixed monthly payments for up to 10 years—an approach that often minimizes the interest the borrower will pay over the life of the loan, in comparison to other payment plans, but maximizes monthly payments.
Some borrowers, particularly those who are cash-strapped, may benefit from an Income-Driven repayment plan. These plans, the newest of which became available last year, cap student-loan repayments at 10% to 15% of a borrower’s annual discretionary income—an amount that is determined by a formula that includes the borrower’s income and family size, among other factors. Using the Income-Drive Repayment plan, a borrower can free up cash for other long-term financial goals, such as saving for retirement.
Income-Based Repayment plans offer the possibility of loan forgiveness after a set number of years of on-time repayments from 10 to 25 years, depending on the plan and the borrower’s profession.
If you are looking to reduce monthly payments, income-based repayment options are more attractive than older alternatives, including “graduated” and “extended” plans. Graduated plans start with lower payments that increase every two years and eventually surpass the standard fixed payment. Extended plans lower monthly payments by allowing up to 25 years for repayment.
Borrowers whose debt is two-thirds of their income or more are likely to qualify for at least some of the various income-driven repayment plans. Review Income-Based Repayment Plans details at FinAid.org .
MISTAKE NUMBER 2: Failing to Understand Loan Types
There are two basic types of student loans: public and private. Interest rates on public loans are set annually by a formula based on the yield of the 10-year Treasury note. With private loans, banks set interest rates using a borrower’s credit history.
To understand repayment options, it’s important for borrowers to compile a list of their loans, including the loan type, principal amount, and interest rate. For public loans, borrowers can go to the National Student Loan Data System at nslds.ed.gov .
Borrowers need to know the interest rates on their loans to figure out whether it makes sense to refinance or consolidate what they owe. With refinancing, a borrower takes out a new private loan to pay off some or all of his or her existing loans, typically at a lower interest rate. With consolidation, the borrower combines some or all existing federal loans at the weighted average interest rate on the old loans.
To understand which Income-Driven repayment options borrowers are eligible for, they’ll need to know the dates when they borrowed. For example, to use the popular Pay As You Earn (PAYE) method—an Income-Driven plan that frequently generates the lowest monthly payments and the highest projected loan forgiveness—a borrower can’t have borrowed before Oct. 1, 2007 and must have taken out at least one federal loan on or after Oct. 1, 2011.
To see what monthly and total payments would be under the various repayment options, borrowers can plug their loan information into the U.S. Education Department’s online Repayment Estimator . Among other things, this tool assumes income will rise 5% a year. If borrowers want to control that and other inputs such as the number of children they plan to have and information about their spouse they can use the Student Loan Repayment Simulator sponsored by the nonprofit VIN Foundation.
MISTAKE NUMBER 3: Failing to Research Student-Loan Forgiveness Programs
Borrowers with public loans who use Income-Driven Repayment plans may also receive partial loan forgiveness.
Under the Federal government’s Public Service Loan Forgiveness program, teachers, law-enforcement employees, doctors, lawyers, and others who work full-time for 10 years for certain types of nonprofits or government are eligible to have their remaining balances forgiven tax-free after 10 years of payments. To ensure they will receive loan forgiveness, they should use an Income-Driven Repayment plan.
For those not in public-service jobs, loan forgiveness is less generous. To qualify, these borrowers must repay their loans for 20 to 25 years—the exact term depends on which Income-Driven Repayment plan they select. In addition, they must pay income tax on any debt that is canceled—a payment that can amount to as much as one-third or more of the forgiven amount.
Visit FinAid.org for more information about Public Service Loan Forgiveness.
MISTAKE NUMBER 4: Prioritizing Student Loans at the Expense of Retirement Savings
In a push to become debt-free, many borrowers prioritize paying off student loan debts over saving for retirement.
A recent report from Morningstar subsidiary Hello Wallet found that someone with a starting salary of $50,000 who pays off a $20,000 student loan ahead of schedule but skimps on retirement savings—by contributing only enough to an employer-sponsored 401(k) plan to receive half the employer’s 3% matching contribution—will wind up with a net worth at age 65 that’s $150,000 below where it would have been had he or she contributed enough to receive the full match and repaid the loan over a longer period, by making the minimum required payment.
If payments under a 10-year Standard Repayment plan leave a borrower too cash-strapped to get an employer’s full matching contribution, (and the employee doesn’t have room to cut spending), the borrower should consider an Income-Driven Repayment plan.
Borrowers should use the cash they free up to set aside at least three months of expenses in an emergency fund. Then, they can save enough in their 401(k) plan to receive their employer’s full matching contribution. Their next priority should be to pay down any high-interest credit-card debt they owe. Anything left over should go into a retirement plan.
Borrowers are likely to earn a higher return in stocks and bonds—that will compound for decades—than they would by extinguishing student-loan debt at today’s low interest rates. In addition, the more a borrower contributes to a traditional 401(k) plan, the lower his or her adjusted gross income reports, which will help reduce Income-Driven student-loan payments the next year.
MISTAKE NO. 5: Automatically Refinancing or Consolidating
Borrowers struggling with private loans with high interest rates might look into refinancing. Online lenders including Social Finance , Common Bond , and First Republic Bank offer attractive deals to those with healthy credit scores and good prospects for future earnings.
Borrowers can refinance public loans too, but they should be careful to weigh any interest-rate reduction they receive against the benefits they’ll lose by swapping their public loans for private loans. These include the flexibility to suspend their payments if they become unemployed or to use an Income-Driven Repayment plan.
The decision to consolidate requires analysis. Consolidation makes it easier to keep track of and repay student debt. It also allows borrowers to swap loans issued under the discontinued Federal Family Education Loan program for a new Federal Direct loan—a prerequisite to using certain income-driven repayment plans.
But borrowers who consolidate all their loans lose the flexibility to pay off the ones with the highest interest rates first. Borrowers who want to maintain that flexibility don’t have to consolidate all of their loans.
Learn more about refinancing options and consolidation by visiting theFinAid.org.