For those of you that read every week, recently discussed how to figure out where your money is going, and setting a budget (Financial Freedom: Finding a Starting Point
and Creating a Budget: The 50/30/20 Budget System
). The whole point of setting a budget is to give every dollar a name, and the reason for doing THAT is to set yourself up for financial freedom. This means freedom from debt, and freedom to do the things in life that you really want whether it be travel plans, early retirement, start working part-time so you can write that book you've been dreaming of.... One of the things that holds you back from living the life you really want is debt. Once you've established the dollar amount in your 20% "Goals" category, you can choose to allot a certain amount of "extra funds" to paying off your debt.
Today, I would like to start addressing on kind of debt in particular: student loan debt. With the cost of tuition on the rise, wages are simply not keeping up. Parents frequently don't have the money to foot large tuition bills. The end result being college graduates that are crippled by student loan debt. For those who have it, getting out of student loan debt is key!
If you have federal loans, step one is knowing your payment plan options. The federal government has generously placed a ceiling on their student loan rates (6.8%) and offers a large variety of plans under which you can keep current on your payments (keeping current is really important). The only drawback is that choosing a plan can be confusing. So, here is the breakdown.
Standard Repayment Plan:
The standard repayment plan offers the highest monthly obligation. The benefit is that it is over in 120 payments (if you don't pay anything extra). That is 10 years. It sounds like a long time, but it can certainly be lessened with extra payments. It is important to note, that this is the plan you are automatically placed on, if you do not take any action to "choose an alternate plan." This plan is likely to have the lowest interest payment over the life of the loan.
Note: In some cases, it could be a 5 year repayment term, but that is not typical. The 5 year term, is generally for borrowers with very low balances.
Graduated Repayment Plan:
Under this play, the payments are less expensive than in the standard repayment plan for the first two years, then they jump up to an amount that is higher than the standard. This payment plan is good for graduates that want to begin payment right away, and expect their income to raise within a couple of years of graduate. If working in a field that offers a good income increase with a couple of years of experience, but lower starting wages, this could be a good choice. This payment plan is typically structured for 120 months as well, so the loan is paid off in 10 years. Additionally, this plan does cost more in interest over the life of the loan.
Extended Repayment Plan:
This payment plan is usually a fixed monthly dollar amount (although graduated is possible), and usually spread over a 25 year term. While it doesn't sound great to be in repayment for that long, it is useful for people that have gone into fields with lower salaries, or those with very high loan balances. The drawback is that this does create a much larger interest payment over the life of the loan.
Income Based Repayment Plan (IBR):
This plan sets the borrowers monthly payment obligation to approximately 15% of their discretionary income. In order to calculate this, the borrower is required to submit proof of income on an annual basis. In other words, the payment can change each year, but it should be within the realm of affordability. Be careful, if you are on this plan and fail to submit your proof of income on time, you will become automatically enrolled in the standard plan, which would clearly create a huge increase in payment amount. If the borrower is enrolled in this payment plan, and the loan still isn't paid off in 25 years, it will be forgiven by the federal government. That's a pretty good deal for those who anticipate continuing to be in a lower wage profession for an extended period of time. The drawback is obviously, making payments for almost as long as a mortgage! On the other hand, if you work for a non-profit of some sort, being enrolled in this plan is a huge bonus because your balance will be forgiven after only ten years (assuming you make 120 consecutive payments that are on time, and continue to work for a non-profit). Another important thing to note, you will end up paying taxes on the amount that was forgiven (it's basically considered income). In order to be eligible for this plan, you must demonstrate a "partial financial hardship."
Pay As You Earn Repayment Plan (PAYE):
This is a plan that is not available to everyone. In order to be eligible for this plan you must have been a new borrower as of Oct. 1, 2007, and had your loans disbursed on or after Oct. 1, 2011. This plan works much like the IBR. Monthly payments are approximately 10% of discretionary income. Borrowers must prove their income on an annual basis. Remaining balances are forgiven after 20 years, 10 for public service (non-profit) employees. In order to be eligible, you must demonstrate a "partial hardship" financially.
Income Contingent Repayment Plan (ICR):
Under this plan, borrowers pay for up to 25 years (then balances are forgiven if still in existence). The monthly obligation is calculated to be based on discretionary income (approximately 20%) as well, so the payments can be cheaper, similar to PAYE and IBR. The benefit to this plan is that you don't have to prove a financial hardship in order to qualify for it (which is a requirement of IBR and PAYE). Public service employees (non-profit) can have their loans forgiven after 10 years under this plan as well.
Income Sensitive Repayment Plan:
If you don't qualify for ICR, you may qualify for this one. Monthly payments are from 4%-25% of total gross monthly income. The payment amount must be greater or equal to the amount of interest accruing on the loan. There are some extra rules to this one that makes it very different from the others. For example, you need to qualify again each year, and you can only be on this plan for 5 years, then you are literally required to enroll in a different plan.
In general, the standard payment is going to get you out of debt the fastest, however if you have a relatively low income, and expect it to stay that way, several of these plans will offer you a lower monthly obligation. This can be a great strategy if you work as a Public Service employee (for a non-profit). Either way, several of these plans will allow you to kiss you debt goodbye after a fixed period of time. You will be taxed on the amount forgiven, but the loans WILL be gone. If you work in the public service arena, I definitely think you should take advantage of this, because you loan forgiveness occurs after ten years. For everyone else, if you can manage the payment under the standard plan, please give it heavy consideration. While having your loans forgive is great, do you really want to pay them for 20 or 25 years?
If you want to do more research on payment plan options Federal Student Aid
is a government website that offers a lot of additional information.