In this edition of the Sherpa Mailbag, we will take a look at a very interesting student loan dilemma. For the next year, Tony may have an excellent salary, then he may be making a shift to a lower paying government position. He may be in the lower paying government job for just a couple years, or indefinitely. Knowing his salary will be briefly large, but then drop, Tony is trying to put together a potential strategy. He also worries about the future of the Public Service Loan Forgiveness Program (PSLF).
I was hoping to ask your advice regarding a repayment plan. I am a bit at a loss. I graduate in 2019 and am considering working for a firm for a year before leaving to clerk for 2 years (from Sept 2020 through Oct 2022). After that, I am not entirely sure where I want to end up. However, I may want to go into government and would like to preserve the option of qualifying for the forgiveness program that eliminates loans for those who have been in government for 10 years.
I’ve been following the news regarding issues people are running into with respect to this program and I’d like to make sure I still qualify. Can you advise as to which plan (or plans, if I should change at some point) make sense? I would have a big law salary until I clerk.
The Big Question
While Tony’s question is specific to the legal career field, many others may face a similar student loan issue. A borrower may be looking at a ton of overtime for the next year, but expect that the available overtime will taper off. Another borrower may have the option of living rent free for a year, which means their expenses will take a dramatic jump in 12 months.
The big question for borrowers with temporality high income is not an easy one to answer… what is the best strategy for repayment?
Tony’s issue is complicated by the fact that he might be looking at a version of the future where he doesn’t make a ton of money, but becomes eligible for Public Service Loan Forgiveness.
The First Step
Before we add any complication to the strategy, step number one will be the same for most borrowers: get the private student loans paid off in full.
Unlike the federal loans, private loans have a more rigid and demanding repayment requirements. Borrowers with temporary high income are well situated to knock out some or all of their private student loan debt. This should be the first objective. Living with federal loans on a lower income isn’t aways easy, but it is manageable for most. Private loans can make things significantly more difficult, so elimination of private student loan debt should be a priority.
Another advantage of the larger income is that these borrowers will have a much better shot at refinancing their private loans at a lower interest rate. The higher income means a better debt-to-income ratio and better odds of approval. By utilizing a private loan refinance, borrowers can lock in a lower interest rate and potentially lower monthly payments going forward.
The approach with the refinancing of the private loans is two-fold. First, by locking in a lower interest rate, the time at a high salary can be most efficiently used for paying down the principal balance by paying extra each month. Second, by refinancing at a lower rate or a longer loan term, borrowers can set up future flexibility for lower income years.
Tips For Refinancing1) Only refinance private student loans – if federal loans are refinanced with a private lender, they lose federal protections like income-driven repayment plans and loan forgiveness. This would be a mistake for borrowers anticipating a drop in income.
2) Make sure to shop around – all lenders evaluate applications differently. The company that advertises the best rate may not actually offer the best rate. We suggest checking rates with 3-5 student loan refinance lenders.
Aggressive Repayment vs. Forgiveness
Generally speaking, the best way to pay off student loans is to aggressively attack the debt until it is gone. This is because the fast repayment reduces interest spending over the life of the loan.
Federal loans and student loan forgiveness options complicate things because the way to maximize forgiveness is to spend as little as possible over the life of the loan.
These strategies are essentially opposite. For people like Tony, who are unsure of what their ultimate approach will be, this can be a problem.
The good news is that there is a way to have the best of both worlds…
The Middle Ground Approach
Borrowers who don’t know whether they will be aggressively pay off their loans or chase forgiveness can try to do both at the same time.
The middle ground approach requires a borrower to pick the repayment plan with the lowest monthly payments that is eligible for the desired forgiveness plan. As far as the federal government and the loan servicer is concerned, this is a borrower who is working towards loan forgiveness.
At the same time, the borrower is behaving financially as though they are aggressively paying off their loans. However, instead of putting the extra money they generate each month towards the debt, it gets put in a high interest savings account.
If the borrower opts to aggressively repay their debt, they can empty the savings account and knock out some of their debt. If the borrower ends up going for forgiveness, the money can be used as a down payment on a house or towards retirement.
This approach also works for people who are concerned about the long term viability of their student loans forgiveness program. If forgiveness works out, great. If it doesn’t, Plan B is ready to go.
The cost of going this route is the difference in interest rates. If the high yield savings account is earning 2% and the loan charges 6%, the borrower is losing out on that gap interest. The higher the interest rate of savings and the lower the interest rate on the loans, the more efficient the middle ground approach becomes.
Borrowers like Tony can stash a bunch of money from their high paying job in a savings account and then have the resources in place if he chooses not to go down the government path.
The accumulation of funds may also make it clear when chasing forgiveness is no longer cost effective. Sometimes pursuing student loan forgiveness ends up costing more than just paying off the loan in full. This is due to the interest that accumulates over the life of the loan before it is discharged. Tony may realize that he can put such a large dent in his debt with his high salary that it just makes sense to pay it off in full. This analysis requires doing a bit of math, but can be helpful in planning.
Picking a Repayment Plan
In a situation like Tony’s there really isn’t a definitive “best” repayment plan. Finding the ideal plan will require a bit of research and depend in part upon a borrower’s marital status, and when they started school. Be sure to check out our Guide to Picking the Best Federal Repayment Plan.
Borrowers with larger debts and smaller incomes will want to pay special attention to the Revised Pay As You Earn Repayment Plan. The special treatment of excess interest that can accrue is especially helpful for borrowers pursuing forgiveness, but not certain that they will go that route.
Smart student loan planning requires more than just picking an ideal repayment plan. There are a number of logistical issues that borrowers should consider.
- Income Certification Strategy – Borrowers can certify their income via their most recent tax return or recent pay stubs. Recent graduates will show very little income on their most recent tax return, especially when compared to their new paychecks. For these individuals submitting the most recent tax return makes sense. Similarly, borrowers who have moved on from a high paying job into a lower paying job will find submitted a recent check to be preferable.
- The future of Student Loan Forgiveness – As Tony noted in his email, there is always the danger of programs like PSLF getting eliminated. Proposals to eliminate PSLF get headlines, but are unlikely to become reality. This is because passage through Congress would be highly unpopular (and because many Congressional staffers are PSLF eligible themselves). Even if the program was eliminated existing borrowers would likely be grandfathered in as PSLF is a term of the student loan contract signed by most borrowers. For this reason, all proposal to eliminate or reduce PSLF have grandfathered in existing borrowers.
Borrowers like Tony who have a limited period of high earning need to make the best of their situation. We have covered the ways to maximize things from a student loan perspective, but it is important to also consider other types of debt, retirement aspirations, and other financial goals.
There isn’t a one size fits all approach to this situation. The most important thing for any borrowers is to carefully consider all of their options and to stick to their budget. When you have a large income, it isn’t always easy to both plan and act like your income is about to be much smaller… but it is critical.