Does Your Student Debt Give You the Chills?
Being a fairly new resident to Jacksonville, Florida, and having not yet lived through a winter season, I didn't realize how cold it could get this time of year. I thought Florida was supposed to always be warm. Boy was I wrong. It has been in the low 40s for much of the winter. Brrrr! I envisioned myself on the beach while everyone else freezes back in my hometown, Columbus. Let's just say I'm really glad I didn't throw out all of my sweaters and winter coats when my wife and I moved our family south.
Speaking of cold snaps, owning warmer clothes will never cure the chill I get every time I see a costly student loan mistake. These errors quite frequently cost a borrower $20,000 - $50,000. For higher education degrees, like doctors and lawyers, those mistakes can often exceed $100,000.
Unfortunately, I see too many young professionals mismanaging their student debt. The pattern is more recurring than I care to admit. Quite frankly, much of the mismanagement stems from borrowers being paralyzed to do anything. They are overwhelmed with the reality of managing 15 loans with 4 different lenders. Imagine managing your other debt this way, like a car loan or a mortgage... It would be a nightmare. The problem is, it truly is a nightmare if you carry a significant amount of student debt.
While I fight off my cabin fever, I decided to use that time to help other student borrowers cure their bad dreams. Having helped several clients overcome their own set of student loan problems, one of the best ways to get in front of the issue is to make more borrowers (and their parents) aware of what pitfalls they should be avoiding. Today's blog article will kick-off by examining the 4 most common student loan mistakes and what you can to do to avoid those landmines. Then, I will present 2 case studies, as seen with my clients. That way current and future borrowers understand just how important it is to have a solid game plan in place.
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4 Most common Student Loan mistakes
1) Refinancing Too Soon
The biggest mistake I commonly see with Federal student loans is a young professional that is too eager to lower their high interest rate debt through refinancing. On the surface, this makes complete sense because refinancing is how we have been conditioned as consumers. The impulse is to immediately reduce the interest cost with one of the big advertisers like SoFi or CommonBond. It's not a knock against these companies, but their brand awareness has made it such that the borrower fails to consider other alternatives, like debt forgiveness.
Essentially, there are 2 forms of debt forgiveness -- Public Service Loan Forgiveness (PSLF) and long-term debt forgiveness (debt gets cancelled in 20-25 years). Furthermore, there are 3 types of Income Driven Repayment (IDR) plans that are necessary for qualifying for debt forgiveness -- Pay As You Earn (PAYE), Revised Pay As You Earn (REPAYE), and Income Based Repayment (IBR). The big one, PSLF, is available to full-time employees (30+ hours) of a qualified public service organization (501.c.3). In order to qualify for PSLF, the borrower has to make on-time payments under PAYE, REPAYE, or IBR for 120 months and then any remaining debt balance gets forgiven, tax-free.
Why are making payments under PAYE, REPAYE, and IBR a good thing? Because monthly payments under PAYE and REPAYE are calculated by taking your income minus 1.5X the poverty rate (discretionary income) and multiplying that number by 10%, divided by 12. IBR uses the same formula, except that it is 15% of discretionary income. Unless you are making the big bucks, these payment plans will be far less than the 10-year standard repayment plan. Note, there are other nuances to these IDR plan that I am leaving out of today's article for the sake of brevity.
Assuming you are able to pay a lower amount under one of the IDR plans and qualify for PSLF, the odds are your savings will be greater than what you get from refinancing when your debt balance exceeds your annual gross income. In addition, the lower payments with an IDR plan can still be better for someone who can't afford the standard payment plan, and is able to get their debt forgiven through the long-termer options that take 240-300 months. I suggest using caution, as there are tax issues to watch out for. More on that later (see mistake #4).
The problem with refinancing is that once your loans are out of the Federal program, they are no longer eligible for debt forgiveness. Worse yet, the fallback provisions like forbearance and deferment are much less generous through the private lenders. In other words, if you lose your job, your Federal lender will allow you to stop making payments without defaulting on your loans, as long as you request forbearance. Furthermore, if a job layoff lasts for an extended period of time, you can select one of the IDR plans and earn credits towards debt forgiveness while you pay $0 every month. While I don't condone leaving your debts unpaid forever, I think it's very important for a borrower to understand the importance of the flexibility offered by the Federal program. A private lender, unfortunately, won't be as forgiving and usually put a limit of 3-12 months with their forbearance program.
I am also not saying don't refinance. In fact, you should probably consider refinancing any existing private lender debt -- loans originated at Wells Fargo, Sallie Mae, etc. What I am saying is make sure you evaluate the financial benefits of PSLF and long-term debt forgiveness before you submit an application to refinance.
2) Failing to (Appropriately) Consolidate FFEL Loans
The Federal Family Education Loan program, otherwise known as FFEL, was a public-private student lending partnership at the state and local level. Additionally, FFEL was the second largest student lender behind the Direct loan program. However, on June 30, 2010, upon the passage of the Health Care and Education Reconciliation Act, the FFEL lending program was discontinued.
Why does this yawn-worthy history lesson matter? Anyone who borrowed a student loan before 2010 likely has FFEL loans, unless that debt was since consolidated. The problem with FFEL loans is that they do not qualify for public service loan forgiveness. Furthermore, FFEL loans do not offer repayment under the lowest income-driven plans at 10%, which are REPAYE and PAYE. Instead, the only option available is "old" IBR, which is 15% of income.
Fear not, there is a solution. Consolidating FFEL loans allows that portion of debt to fall under the Direct Federal program, which is eligible for PSLF. It also allows the borrower to use REPAYE and possibly PAYE. If you want to minimize payments, you would much rather pay 10% of income than 15% of that same income.
The tricky part with consolidating FFEL loans is that the clock resets your payments back to 0. This matters if you are aiming to get your debt forgiven in 20-25 years and already accrued 7 years towards forgiveness. Consequently, the lower payments associated with REPAYE or PAYE need to be weighed against the forfeited number of months already earned towards debt forgiveness. If you aren't sure what to do, this is a good time to leverage the expertise of a financial advisor who understands the important details.
Let me save you from calling your loan service provider... That is if you want good advice. The agent on the other line will not help you run the calculations or provide the necessary analysis because they are not held to a fiduciary standard. Therefore, there is no legal obligation for that agent to act in your best interests. They are merely there to help service the loan. That's it. Even then, they are notorious for making life difficult.
3) Selecting the Wrong Federal Payment Plan
Write this down and put it in safe place you will remember. There are 4 payment plans you should never select: Graduated, Extended, "New" IBR, and Income Contingent Repayment (ICR).
I can't tell you how many times I have seen a client or prospect in Extended or Graduated repayment plans because they wanted the lowest monthly payments. It makes a lot of sense because every penny matters in your younger years and these two plans often provide the lowest initial payments. However, the Extended and Graduated plans end up being the most expensive ones in the long-run. The kicker is that payments made under Extended and Graduated do not qualify for PSLF or long-term debt forgiveness. Meaning, when you switch to a new payment plan, all those payments you made under the Extended or Graduated plan did you very little good, other than maybe keep your interest costs from spiraling in the wrong direction.
Selecting "New" IBR as your payment plan is a bad idea because if you qualify for this plan you qualify for PAYE. PAYE is always better because when interest capitalizes, PAYE limits the amount of interest that gets tacked on to the loan to 10% of the balance. Whereas, interest capitalization with "New" IBR is uncapped. In layman's terms, PAYE's is less expensive than "New" IBR.
ICR is the last of these offenders. I can't think of one good reason for anyone to select this repayment plan. Thankfully, I have not seen any of my clients or prospective clients in it. However, if you are one of the few outliers, just know that payments are 20% of discretionary income vs. 10% - 15% with the other IDR plans. Pretty straightforward.
4) Neglecting the Impact of Taxes & Filing SEPARATELY
From what I gathered in my conversations with friends and clients, there are a good number of young professionals who are planning to get their debt forgiven the long-term route in 20-25 years. Unfortunately, a large percentage of those I spoke with were unaware that when their debt is forgiven (without PSLF) the remaining loan balance is added to their taxable income the year it is forgiven.
Example. Let's say you are making $150,000 25 years from now and you have $90,000 in student debt being discharged. Well guess what... Your income for the year is now $240,000. Using the Trump tax reform rates, that extra $90,000 unexpectedly dropped a tax bomb of $29,400 on the borrowers lap. The key here is to make sure you have a savings plan in place to pay the tax bill later on. Otherwise, little Johnny might have to finance his college tuition and suffer the same hardships you once had to live through.
The other big tax mistake is for a young married couple to file their tax returns separately with the sole purpose of reducing monthly payments. This can be a good strategy, however, simply filing separately while failing to consider the tax implications is a huge no-no.
To get an idea, the general "formula" for deciding the cost-benefit of filing jointly versus separately is to compare the total tax costs against the annual cash savings that resulted from lowering monthly payments on your student debt. What I mean by total tax costs is that the borrower needs to project the potential tax liability at the end of their loan period (20-25 years), as well as calculate the annual tax increase/decrease for filing their returns as married separately. Anything in the surplus side would suggest that filing separately is a good financial plan.
Other Mistakes worth noting
Forgetting to recertify your IDR plan on your anniversary date. Failing to certify automatically bumps your payments up to the standard 10-year payment plan.
Not verifying PSLF credits and assuming your employer is a 501.c.3.
Allowing interest to accrue, snowball, and then capitalize.
Case Study Examples
Congratulations if you have read everything so far. Most readers have likely skipped ahead by now. I can think of far more interesting topics than student debt. As hard as this stuff is to digest, it will make a big difference in your life financially. The key is you need to commit the time and research to get a plan in place, which will help you make the right decisions. To that end, let's apply your newfound knowledge and see exactly how these student loan traps affect your bottom line.
Real Life Example #1 - Refinancing Too Soon
One of my younger client's, Suzie, came to me with $194,100 in student debt at an interest rate of 6.8%. She worked for The Ohio State University (501.c.3) and planned to do so for the foreseeable future. She made a $35,000 salary during her veterinary fellowship, which increased to $125,000 in 12 months, after she was fully certified. She was in the 10-year standard payment plan with a projected total cost was $268,000. Compare that to refinancing with a private lender at 4% for the same 10-years and the total interest savings of $32,000 looked like a no-brainer.
Note, refinancing was the route we agreed to move forward with after my initial analysis... That is until I stumbled across an XY Planning Network podcast with guest, Heather Jarvis, a national student loan guru. It was at that point I realized Suzie and I were about to make a big mistake. Shortly thereafter, I signed up for Heather's 3-day course on student loans, so that I knew exactly how to help Suzie navigate a much more complex decision than I originally anticipated. Upon regrouping and drafting a more complete analysis, Suzie and I determined she was eligible for PSLF and that her new payment plan (PAYE) would save her a total of $158,000. In other words, had Suzie refinanced without careful consideration she could have cost herself $126,000!
Real Life Example #2 - Tax Filing Status and Failing to Consolidate FFEL Loans
It's your lucky day. My next clients, Jerry and Elaine Seinfeld, offer a two-fer. Jerry and Elaine are married with 2 kids enrolled in daycare. Jerry is an attorney pulling in an annual salary of $92,000 and Elaine is a 2nd grade teacher making $41,000. The Seinfeld's came to me with $284,000 in student debt -- all tied to Jerry. They were making monthly payments via the "old" IBR plan, and half of Jerry's loans were from the FFEL program. Basically, the Seinfeld's needed help right away.
Why the urgency? The Seinfeld's chose to file income taxes separately because Jerry received a $10,000 pay raise the prior year. That same tax year they took an early withdrawal from Jerry's IRA to pay off some medical expenses. Meaning Jerry's IBR payments were going up by $250 per month. Also, Jerry was on the fast track to making partner at his firm, which meant substantially higher raises (and higher loan payments) in the near future.
These string of events caused the Seinfeld's to panic because their cash flow was very tight paying for 2 kids in daycare, along with a large student loan burden looming over their heads. Essentially, they felt trapped and it caused the Seinfeld's to make a hasty decision to file their taxes separately. A decision that meant they would be forfeiting a $4,200 tax refund. Here's the problem, the Seinfeld's didn't compare the cost of filing separately to the difference in monthly payments with the student debt. Remember, their payments went up $250/month, which is $3,000 annually. $3,000 is less than $4,200 or a difference of $1,200 per year. Meaning the Seinfeld's should have never filed taxes separately to begin with. Some might scoff at the obvious, but the problem is most people don't take the time to slow down and carefully analyze their entire financial picture.
The second area of opportunity with the Seinfeld case was consolidating Jerry's FFEL loans. Restructuring the FFEL loans meant that all of Jerry's Federal debt qualified for the REPAYE plan. Therefore, the Seinfeld's monthly payments went from 15% to 10% of discretionary income. This bumped their payments down to about where they were before we met. In other words, the Seinfeld's saved $250/month in monthly payments with REPAYE vs. IBR. And don't forget, they saved $4,200/year in taxes. All in all our comprehensive analysis projected the Seinfeld's would save about $97,000 between their student loans and taxes over the next 25 years.
Get to the ROot of it
The complexity and administrative burden that is inevitable with student debt is a tall order for most. For anyone feeling shackled by their debt, not having a plan is planning to fail. More importantly, don't let fear of not knowing where to start get in the way of taking action. By removing the root of your financial problems, you can begin living a more prosperous life. With a student loan plan in place it becomes a lot easier to buy that new dream house you had your eye on, pay for your children to go to college one day, and eventually retire with a substantial nest-egg.
For additional resources, check out the Ultimate FAFSA Guide.