Student loan borrowers should prioritize plans where they pay the least amount over time.
Many borrowers with student loans through federal programs are blessed with up to eight – if you include consolidation – repayment options.
Having this many choices allows borrowers to afford their student loan payments and ensures that they can find just the right one to meet both their budget and financial goals. Unfortunately, too many choices can also be a curse.
The Student Loan Ranger sees a lot of consumers overwhelmed by these choices, and we fear that making the wrong decision could cost them a significant amount of money. Here’s how to choose a repayment plan with confidence.
Pay the Least
First, let’s clarify your goal. Many borrowers, especially recent graduates, focus on getting the lowest student loan payment possible or determining the best way to maximize programs, such as Public Service Loan Forgiveness.
But rather than trying to get the lowest payment or have the most debt forgiven, you should be focusing on paying the least amount possible over time. For borrowers potentially eligible for forgiveness, that might very well mean getting the lowest payment possible. But for those with average incomes or average debt levels, the answer might actually be to find the highest payment you can afford.
Here’s why: Student loans, like most consumer debts, accrue interest daily. This means that the more quickly you pay off the loan, the least amount of interest you’ll pay over time.
While it may feel good to get some of your loans forgiven or to have extra money every month, the long-term cost of that may not be worth it. Let’s look at some examples.
Consider a borrower who owes $25,000 in Stafford loans and has an adjusted gross income of $25,000. She’s single and has no children.
For these calculations, we used the Department of Education’s student loan repayment calculator, which assumes a 5 percent income increase per year but no change in marital or dependent status. Under a 10-year standard plan, this borrower would pay back a total of $31,820 with a payment of $265 per month for 10 years.
Under a graduated repayment plan, she’d start out with a payment of $150 per month, end with payments around $450 per month and pay back a total of $33,578. But under several of the income-driven plans, this borrower pays $58 per month to start, $137 at the end and, if she qualified for PSLF, only repays a little more than $11,000 in total with approximately $25,000 forgiven tax-free.
If she doesn’t qualify for PSLF, under the Pay as You Earn program, she would start out with that same $58 payment amount, end up with a payment of $265 and receive a little more than $11,000 in loan forgiveness, which would be taxed as income – but only after 20 years and repaying almost $37,000. While more than $10,000 of her debt would be forgiven, it would cost her almost $6,000 more out of pocket than the 10-year standard plan would have.
Making a Decision
So how do you decide? The best way is to create your budget first, as well as set some long-term financial goals.
If your federal debt level is very high and your earning potential is not so high, you may be better off pursuing forgiveness. If your income is low now but you expect it to increase, it’s probably OK to take a lower payment now while you establish a solid emergency savings fund and meet other financial obligations, but plan on increasing your payment every time your income increases.
There’s no prepayment penalty on student loans – regardless of what plan you are on – so if you can afford to do so, it’s almost always a good idea to pay beyond what your required payment amount is, assuming you aren’t pursuing forgiveness.
The other factor to consider is any other debt you have. Federal student loans have many more options if something bad happens financially in the future.
If you have high-interest credit card debt or private student loans, it may make sense to minimize the federal student loan payments until you have resolved those other debts. Remember, too, that depending on your income, you may be able to claim the interest on your student loans as a tax deduction, which is another reason to consider paying the federal loans last.
Finally, don’t set your payments and forget them. Over time, our financial goals and situations change, so it‘s a good idea to review and crunch the numbers again at least every two years.
There’s no one answer to the question of which repayment plan you should choose. If loan forgiveness programs will generate the least amount out of pocket over time, go for the lowest payment amount.
If not, go for the highest payment you can afford while still being smart about your other financial responsibilities. Remember, the name of the game is paying the least amount over time – not the least amount today.