What's The Current Situation
Since the beginning of the pandemic, President Trump suspended federal student loan payments with 0% interest accruing which has provided a lot of relief for borrowers since US student loan debt now exceeds $1.6 trillion. The average loan amount is predicted to be $38,147 for a 2021 high school graduate, and can expect the following average interest rates:
- 4.60% for undergraduates
- 6.16% for graduate students
- 7.20% for parents and graduate students taking out PLUS loans
Under President Biden, federal loan payments are expected to come back in May after extending the pause on federal loans from February 2022. Student loan borrowers should look at their options now to see the best one to take.
A Common Scenario For New Federal Loan Borrowers
The standard term for paying off student loans is ten years, so an undergrad with 4.60% will have a monthly payment of $337.05 if they have $32,371 in federal loans.
The average salary for a college graduate is $55,260. From my experience, a single person from Oregon would have a budget something like this.
Gross Income
$55,260
Taxes and other deductions
5% contribution to traditional 401k – $2,763
Federal Taxes (7.68% effective rate) – $4,245.40
State Taxes (5.58% effective rate) – $3,083.17
Health Insurance Premiums (Bronze Plan for 21 year old) – $3,348.00
Social Security Tax (6.2% rate) – $3,426.12
Medicare Tax (1.45% rate) – $801.27
Oregon Worker’s Benefit Fund (2.2 cents per hour worked) – $45.76
Oregon Transit Tax (0.1% rate) – $55.26
Tax Savings
Student Loan Interest Deduction (first year of paying off loans) – $272.55
Take-home pay
$37,764.54 for the year or $3,147 a month
Expenses
Student loans – $337.05
Rent, utilities, and internet (with a room mate) – $1000
Groceries – $300
Gas – $240
Cell phone bill – $75
Car insurance – $90
Car payment – $250
Streaming services – $60
Gym membership – $40
Savings – $150
Total expenses – $2,502.05
Left over – $644.95
As a rule of thumb, I like to tell clients to save 5% of their take-home income until they reach $10,000 in savings. This will help establish the emergency fund, but more can be saved and should as someone gains more responsibilities. The rest of the take-home pay can be used for entertainment, clothes, gifts, personal development, additional investing, or paying off their student loan debt.
This is a very simple budget for someone and will change depending on someone’s circumstances. But in this scenario, the student loan borrower has some choices to make and can choose one of the following tracks to get rid of their federal student loans.
Pay Off Student Loans From Income
If a borrower has the capabilities to pay off their student loan from their income, they can general do so in the following ways.
Pay off the student loans over the standard ten year period
This will cause the borrower to pay back $40,446 over ten years, making $337.05/mo payments
Pay off the student loans over the standard ten year period with an extra $100/mo payment
This will cause the borrower to pay back $38,460.40 over 7.41 years
Pay off the student loans over the standard ten year period with an extra $200/mo payment
This will cause the borrower to pay back $37,056.45 over 5.83 years
A borrower could also choose the extended payment plan up to 30 years. This would cause the borrower to have a monthly payment of $165.95/mo but pay $59,742 over 30 years.
How to Save Money On Paying Down Student Loans
If someone can afford to make extra payments and has good income security, it might make sense to refinance them with a private lender. A private lender can offer a lower rate or give a bonus of up to $1000 for choosing them as a lender (these bonuses change often).
Finding multiple lenders that offer a bonus can be an excellent strategy to accumulate the biggest bonus while getting a lower rate with the plan to pay off the student loans early. According to Bankrate, some lenders offer rates as low as 1.99% depending on the amount, person’s credit score, and the length of the refinance.
A borrower expecting huge pay raises over the next couple of years could be a good candidate for refinancing, but again it all comes to making the financial projections.
Go For Student Loan Forgiveness
If a borrower is going to have trouble paying off their student loan, they can get on one of the four repayment plans, which would require the borrower to consolidate their loans and have a new weighted interest rate.
To make things simple in this scenario, we’ll say the weighted average turns out to be 4.60%. The four repayment plans are based on the type of loan and when the loan was taken, but here are the general guidelines for the four repayment programs.
- REPAY – pay 10% of income for 25 years
- PAYE – Pay 10% of income for 20 years
- Old Income-Based Repayment – Pay 15% of income for 20 years
- New Income-Based Repayment (for borrowers after 2014) – Pay 10% of income for 20 years
- Income Contingent Repayment – Pay 20% of income for 20 years
If a balance is left over after the forgiveness period, the forgiven amount is taxable. So if someone had $50k forgiven, that money would be added to someone’s tax return, and the taxes on this amount in this scenario would roughly be $15k. So it would be wise for the person seeking forgiveness to start saving $30/mo in an investment account to pay for the taxes in 25 years.
A loan forgiveness payment is based on someone’s Adjusted Gross Income on their tax return. The main ways that someone can lower their AGI for student loans are:
- File Married Filing Separately.
- This is mainly done if one spouse makes significantly more than the other spouse and has a lot of student loan
- Make a contribution to a tax-deferred account like a traditional 401k or traditional IRA
- Make a contribution to a Health Saving Account or Flexible Savings Account
- Take Business Deductions
Then the borrower gets to subtract the poverty guideline level, which is different from state to state. For Oregon, a single person would use $11,770 as their deduction. So if the borrower is on REPAYE, their monthly payment would start at $301, but every year they need to recalculate their monthly payment by submitting their new AGI. Assuming a 2% increase, their final payment would be $383.89 per month, and would have paid off the loan in 10 years.
So, in this case, it wouldn’t make sense to seek loan forgiveness at this salary and loan amount since they standard payment amount is lower over ten years at $40,446 vs $40,993.34.
When Seeking Loan Forgiveness Makes Sense
Let’s say the loan balance was $100k instead. Then the ten-year monthly payment would be $1,041.21, which would make the borrower’s budget tighter. Then getting on REPAYE would make a lot more sense to the borrower because their monthly payment would be $313.33 at a salary of $55,260 and would have $91,688.70 forgiven, which could create a potential tax bill of $20,171.51 and would require someone to save $33.87 for the 25 years.
Whatever choice someone makes, whether making the standard payment or going for loan forgiveness, it’s tough to switch afterward. So it is best to know which is the right path to go down from the beginning. And sometimes, it’s best to go down loan forgiveness than try to pay off the money.
Someone could save the difference and invest and come out ahead. This is a strategy that many doctors use to pay off student loans. The numbers show that their high salary and high student loans make more sense to go for forgiveness. Psychology, it can be challenging to continue paying the loans for 20 or 25 years, but financially it can be the best decision.
If someone can get on Public Service Forgiveness, then loans get forgiven after ten years versus the 20 or 25 years, plus whatever is forgiven is not taxable. So this might be someone’s plan for the first ten years of their career before they pivot into the private sector.
The Last Option But Least Desirable
The last choice someone can make is not to pay off their student loans, which should be the last resort, and the borrower should call the loan provider to make arrangements to get back on track. If someone can’t pay back their student loans, this will typically happen.
After 90 days, the account will be labeled as delinquent, where the three credit agencies will be notified, and someone’s credit will take a hit. So borrowing or getting services like a cell phone plan will be difficult or impossible. Renting a home can also be very hard.
After 270 days, the account will be labeled as default, and the federal government can use its powers to garnish someone’s wages, tax return, or social security in the future.
Know The Deal Before You Accept The Deal
As you can see, paying back student loans is not always straightforward, and borrowers should recognize the deal before they accept it. This blog post can’t cover everything so someone should use it as a general guideline to explore what they should do before committing to a particular plan.
As a rule of thumb, someone shouldn’t borrow more than 50% of their anticipated salary. I understand that specific careers are very competitive, require higher educations and still don’t pay a wage that covers the cost of the education. Realize that if this is the case, being on a loan forgiveness program for 20 or 25 is probably the best-case scenario. Still, if it means they’re in a career they love, then that person made the calculated decision and should be okay with the ramifications.
As a financial planner, I can help people with these student loan scenarios and let them know the deal related to other financial planning scenarios like retirement. Then it is up to the person to decide the path they want to go down. And as a business consultant and career coach, I can help people navigate their career or business to give them the strategy and plan to help them increase their earning potential.
Overall, there are tons of ways to make it happen. It starts off by knowing how to make it happen and then doing the work.
If you think someone can benefit from reading this basic scenario, please share it with them. It could prevent a lot of headaches down the road.
*Before you make any changes with your financial situation, please do your research or consult a professional to ensure you’re doing what is best for you*
