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Paying Off a Student Loan?

Date: January 1, 2017      Publication: Bottom Line Personal      Source:  Mark Kantrowitz, Cappex.com      Print:

Avoid These Costly Mistakes

The cost of college has skyrocketed in recent decades, and so has the burden of student loans. More than 40 million Americans now owe a total of $1.3 trillion in ­student-loan debt. Repaying those loans is especially challenging when borrowers make loan-repayment mistakes—some that even the government is duping them into!

Mistake: Assuming the Department of Education’s new RePAYE program is the best plan for you. RePAYE (Revised Pay As You Earn) allows borrowers who have modest incomes to repay certain government-subsidized student loans at slower-than-normal rates. That can sound very appealing to cash-strapped grads. But the government actually offers four different “income-driven repayment plans,” and for most borrowers RePAYE is not the best. It does not cap monthly payments, so while required payments can be appealingly low for recent grads earning entry-level wages, the payments might skyrocket in future years. RePAYE also gives some borrowers an unwelcome wedding present—a spouse’s earnings must be included in income calculations, which can trigger a sudden spike in repayment requirements. (A cynic might even argue that the government is pushing RePAYE not because it saves borrowers money, but because it will net the government more money.)

Better: The older income-driven ­repayment plan known as Pay-As-You-Earn repayment (PAYE) is always the best option if you are eligible. Unlike RePAYE, PAYE caps monthly payment requirements and lets borrowers exclude spousal income if separate tax returns are filed. Under certain circumstances, PAYE forgives debt sooner than ­RePAYE, too. Consider RePAYE—and Income-Based Repayment (IBR), a third program—only if you do not qualify for PAYE.

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Choosing between RePAYE and IBR is less clear-cut—IBR requires borrowers to devote a higher percentage of their discretionary income to loan repayment…but like PAYE, it caps required payments and provides a way around the marriage penalty. (The fourth ­income-based repayment plan—Income-Contingent Repayment—is never the best option.)

If your total student-loan debt is less than your annual income, skip income-based repayment—these programs won’t benefit you unless you work in the public sector. (Full-time public sector employees typically should sign up for IBR even if they have substantial incomes, because special rules might allow them to have any remaining debt completely wiped away in as little as 10 years.)

Mistake: Consolidating student loans into a single larger loan just to make repayment a little easier or interest rates a little lower. Private lenders make student-loan consolidation and refinancing sound appealing, ­advertising that it will lower interest rates and monthly payments and simplify borrowers’ lives. (The federal government has a Direct Consolidation Loan program as well.)

But for most borrowers, consolidation has more downside than upside. It means borrowers cannot pay off their highest-rate loans first. And replacing federally subsidized student loans with a private consolidation loan often costs borrowers advantageous loan terms.

Example: Federal student loans often let borrowers defer repayment if they enroll in graduate school…reduce repayments if they have modest incomes…or stop making payments entirely if they become permanently disabled. Private loans generally are far less flexible.

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It is almost never a good idea to refinance federally subsidized student loans, particularly if they are fixed-rate loans. It could be worth consolidating and refinancing private student loans if this leads to significantly lower interest rates. In that case, wait at least two to three years after graduation to refinance—recent grads’ credit scores usually are too low to qualify for attractive private loan rates.

In contrast, it might make sense to refinance a Parent PLUS loan with a private lender if the interest rate savings are significant—at least two percentage points is a good rule of thumb. Parent PLUS loans lack many consumer protections provided by ­federal student loans, so the ­downside of refinancing is limited.

Mistake: Skipping auto-debit. Many borrowers are hesitant to have their ­student-loan payments automatically withdrawn from their bank accounts each month because they fear that it gives the lender too much control over their money. But you can cancel auto-debit to regain control at any time. And meanwhile, not only is auto-debit a great way to avoid late or missed payments, but many lenders will lower student-loan interest rates by 0.25 to 0.5 percentage points if you use auto-debit.

Mistake: Paying off the smallest loans first rather than highest interest rate loans. There’s a loan-repayment technique called the “snowball strategy” that advocates paying off the lowest-balance student loans first. The idea is that paying off these small loans in full as quickly as possible will give borrowers a sense of accomplishment that will help them pay off their larger loans sooner.

Better: If you can afford to make more than the minimum payments on your loans, target your loans with the highest interest rates first, not your smallest loans. The faster you pay off high-rate loans, the less you will pay overall.

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Example: Say you have a $10,000 student loan with a 4.5% interest rate and $100 minimum monthly payment…a $50,000 loan with a 7.9% rate and a $200 minimum monthly payment…and you can afford to make $200 in additional payments each month. If you used that extra money to pay off the small, low-rate loan rather than the large, high-rate one, you would end up making more than $4,300 in unnecessary interest payments.

Mistake: Failing to tell lenders how extra payments should be applied. Making payments greater than the minimum required amount is a great way to reduce the overall cost of this debt. But when borrowers try to do this, their lenders often do not apply the extra money in the manner that is most beneficial to these borrowers.

Examples: If the borrower has two loans with the lender, his/her excess payment might be applied to the loan that has a lower interest rate. Or if the borrower sends in an extra check, that payment might be treated as an early payment of the following month’s required payment rather than as an additional payment. In that case, the lender might not charge the borrower for the following month’s required payment, and as a result, the balance of the loan would not be paid off any quicker.

Better: Include a cover letter with any extra payment (or payment in excess of the minimum required amount) clearly stating, “This is an extra payment to be applied to [a particular loan number] to reduce the principal balance of that loan.” If you make an extra payment electronically through a lender’s website, there typically is a way to identify specifically how the money should be applied, such as clicking on a particular loan number. If it isn’t obvious, call the lender and ask how to proceed.

Mistake: Paying off student loans at the expense of employer-matched contributions to retirement plans. In general, it is better to pay down student loans than to invest your money. The one big exception is if your employer offers matching on certain retirement plan contributions. It’s like free money.

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Better: Contribute the full amount matched by your employer before making any college loan payments above the minimum.

COSIGNING MISTAKES PARENTS MAKE

Mistake: Agreeing to cosign a student loan if you intend to refinance your mortgage (or take out any other loan). Lenders will treat the student loan as if it were your own debt. That might inflate your debt-to-income ratio enough that you will not qualify for better interest rates until the student loan is paid off.

Mistake: Letting cosigned loans languish when students do not keep up the payments. Those late or missed payments will devastate the parent cosigner’s credit scores.

Mistake: Making payments for the student if your goal is to be released as a cosigner. Many student loans offer cosigners a path toward being removed from the loan—if the student proves he can make the payments himself. But if the cosigner makes even one loan payment on the student’s behalf, the lender will take it as a sign that the student was unable to make that payment himself and deny the cosigner’s release request. Better: Give the money to the student, and let the student make the payment.

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Source: Mark Kantrowitz, publisher and vice president of strategy for Cappex.com, which helps match students with colleges and scholarships.