While there has been a tremendous amount of attention focused on the nation’s growing student debt burden, far less attention has been directed at the best ways for individuals to pay off their college debt.
I am focusing today on the choices that borrowers face when determining how to tackle their federal student loan debt.
The two federal loans available to students are:
- Direct Subsidized and Unsubsidized Loans for undergraduates and graduate students; and
- Direct Plus Loans for graduate and professional students.
Federal student loan borrowers can choose between two categories of repayment plans.
Time-based repayment. This option offers a 10- or 25-year repayment with a fixed interest rate for the life of the loan. Paying off a loan in 10 years will typically result in the smallest amount of repayment. Consequently, for borrowers who can swing it financially, this will usually be the best option.
Income-based repayment. These plans base the monthly payments on a family’s size and a percentage of the individual’s discretionary income. The payments will change annually depending on these factors. Every year, borrowers must recertify their income and household size for the program. If an individual’s income or family size changes significantly before their annual certification date, such as a loss of a job, borrowers can submit updated information and ask their federal loan servicer to recalculate the payment amount at any time. Any balance that remains after the income-based repayment period ends, which will be 20 or 25 years depending on the plan, will be forgiven. The forgiven amount, however, will be subject to taxes.
There are four federal repayment plans, but the two newest ones offer the most favorable terms:
Both of these plans cap monthly payments at 10% of an individual’s discretionary income. The older choices have higher income caps.
A Tool to Pick the Right Plan
Picking the right repayment method can be tricky. Issues that will impact the choice include: marital status, level of debt and income, all of which obviously can change significantly over the years. Because of this reality, you should tell your clients about the federal Loan Simulator that can direct them to the superior repayment plan for their circumstances.
The simulator allows the user to upload their federal loan data to do the following:
- Estimate what the repayments will be for all the eligible plans based on needs and goals;
- Estimate the impact of changes on income, marital status, tax filing status and household size on the plans;
- Illustrate how to pay off student loans faster; and
- Examine switching to a new repayment plan instead of suspending payments during a rough financial period.
One scenario that your clients or their adult children might encounter is which repayment plan married individuals should choose. Repayment plans do factor in any federal college debt that a spouse has, but spousal income will also be considered for couples filing taxes jointly.
A way exists, however, to exclude spousal income from the repayment calculation. The borrower would have to choose the PAYE repayment plan and file separate tax returns. This choice, however, isn’t a slam dunk because married couples who file separately usually owe more taxes.
Public Service Loan Forgiveness
Earlier I mentioned that the best plan for those who can pay off their federal loans in a timely matter is the standard 10-year payment plan. The main exception to this statement is those who may qualify for the Public Service Loan Forgiveness program.
The PSLF program is designed to encourage borrowers to go into potentially lower-paying public service jobs by offering loan balance forgiveness. Eligible borrowers can have their remaining debt erased if they make 120 payments—which don’t need to be consecutive. Under this plan, the forgiven debt amount is not subject to taxes.
To qualify, borrowers must be employed by a federal, state, local or tribal government, the military or a nonprofit organization. Those eligible represent a wider swath of workers than you might think, since qualifying employers include such entities as colleges and nonprofit hospitals, which means many in higher-paying jobs, like physicians, could be eligible.
The PSLF, which was launched in 2007, has been dogged by controversy because, until recently, few borrowers have had their loans forgiven. There were a variety of reasons for this failure, including consumers misunderstanding requirements, loan servicer problems and paying down loans that weren’t eligible.
In addressing this issue, the federal government announced in October that it was going to temporarily make it easier for hundreds of thousands of borrowers in the PSLF program to eliminate their debt through a temporary waiver that ends on Oct. 31, 2022.
You can learn more about the waiver changes on the U.S. Department of Education website.
Lynn O’Shaughnessy, a nationally recognized college expert, offers an online course—Savvy College Planning—exclusively for financial advisors.