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These 2 Student Loan Mistakes May Leave You out in the Cold

Investopedia logo Investopedia 2/6/2018 Scott Snider
These 2 Student Loan Mistakes May Leave You out in the Cold© John Smith These 2 Student Loan Mistakes May Leave You out in the Cold

The recent cold snap this winter reminded me of the chilly feeling I get every time I see a student loan mistake. Unfortunately, too many young professionals are mismanaging their student debt. These errors quite frequently cost a borrower thousands of dollars, and that cost is further magnified for those with higher education degrees in medicine or law.

Much of this mismanagement may stem from borrowers being too paralyzed to do anything. Some students are managing up to 15 separate student loans with as many as four different lenders. Imagine managing your other debt this way, like a car loan or a mortgage; it would be overwhelming.

Carrying a significant amount of student loans is not only stressful, it can also cost you a lot of money in the end.

Here are two of the most common student loan mistakes, and advice for how current and future borrowers can create a plan to avoid these costly errors:

1. Refinancing Too Soon

The biggest mistake I commonly see with federal student loans is a young professional who 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 by refinancing without considering other alternatives, like debt forgiveness.

Debt Forgiveness and Income-Adjusted Plans

There are two forms of debt forgiveness: public service loan forgiveness (PSLF) and long-term debt forgiveness (debt gets canceled in 20-25 years). Furthermore, there are three 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 is forgiven, tax-free. (For related reading, see: Debt Forgiveness: Escape Your Student Loans.)

Why should you consider an income-driven repayment plan?

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 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.

Assuming you are able to pay a lower amount under one of the IBR 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 IBR 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 longer-term options that take 240-300 months, although there are tax issues to be aware of.

The Problem With Refinancing

The problem with refinancing is 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. 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 it's not a great idea to leave your debts unpaid forever, a borrower should 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 three to 12 months on their forbearance program. In the case of private-lender debt, refinancing is wise to consider. However it's a good idea to evaluate the financial benefits of PSLF and long-term debt forgiveness before you submit an application to refinance your federal loans. (For more from this author, see: Beware of the True Cost of Private Student Loans.)

2. Failing to Consolidate FFEL Loans

The Federal Family Education Loan program (FFEL) was a public-private student lending partnership at the state and local level, and 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. Anyone who borrowed a student loan before 2010 likely has FFEL loans, unless that debt was since consolidated.

The problem with FFEL loans is 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 IBR, which is 15% of income. (For related reading, see: How Student Loan Repayment Works.)

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%. The tricky part with consolidating FFEL loans is the clock resets your payments back to 0. This matters if you are aiming to get your debt forgiven in 20-25 years and have already accrued several years toward forgiveness. The lower payments associated with REPAYE or PAYE need to be weighed against the forfeited number of months already earned towards debt forgiveness. 

When deciding on the correct course of action for paying off student loans, it is important to keep in mind that agents who work for student loan providers are not trained to run calculations or provide analysis on your particular loan situation and therefore may not give you the most accurate information. Seeking out the necessary learning resources for yourself and understanding your own student debt picture will save you from making costly mistakes.

(For more from this author, see: How to Use Financial Rules of Thumb.)

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