Millions of federal student loan borrowers have balances of greater than $50,000. For more than half of these borrowers, their balances are going up according to the latest research from the Brookings Institute.
Owing a ton of money in student loan debt can be terrifying. Making payments and only seeing the debt go up makes a horrible experience even worse.
Fortunately, there are several ways borrowers can protect themselves and minimize damage when student loan interest threatens to cause their federal debt to grow out of control.
Understand Capitalized Interest
The first thing borrowers with growing federal debt should understand is exactly how the federal government charges interest. While interest does accumulate daily, that interest isn’t immediately added to the principal balance. Waiting to add the interest to the principal balance is a good thing because it means borrowers do not pay interest on the interest right away.
Lenders track two key numbers: principal balance and unpaid interest. Borrowers whose monthly payment is less than the monthly interest will have their unpaid interest balance continue to grow, despite making payments. This is a common situation for borrowers who are on income-driven repayment plans and have large balances.
When the interest is capitalized, it goes from being “unpaid interest” and is added into the principal balance. At that point, borrowers now start paying interest on the interest. Avoiding interest capitalization is therefore very important. Sometimes it cannot be avoided, such as switching repayment plans. Other times, it can be avoided, such as failing to submit income verification documentation on time for Income-Driven Repayment plan borrowers.[Further Reading: Avoiding Interest Capitalization]
Use REPAYE to Keep Interest Under Control
Revised Pay As You Earn offers a unique perk not provided by any other repayment plan.
Under REPAYE, borrowers only have to pay 50% of the excess interest that accumulates each month. An example of how this works is probably the easiest way to understand it.
Suppose a borrower has federal loans that generate $500 of interest each month, but their PAYE payment is only $100. That means each month, this borrower has $400 of interest added to their unpaid interest balance, waiting to be capitalized. However, if this borrower switched to REPAYE, only half of that $400 would get added to the unpaid interest tally each month. This feature can save significant money for borrowers with large balances and low monthly payments.
The one major downside to REPAYE is that spousal income is included regardless of how taxes are filed. Borrowers who are on PAYE or IBR and file their taxes as married filing separately because their spouse has income but no federal debt will see higher monthly payments on REPAYE.[Further Reading: Selecting the Best Income-Driven Repayment Plan]
Plan Ahead for Student Loan Forgiveness
Borrowers on an income-driven repayment plan can have their federal student loans forgiven after 20-25 years worth of payments… regardless of their employer or how much they have paid over that period.
While this light at the end of the tunnel is a huge perk, it comes attached to a train in the form of a huge tax bill.
The IRS treats forgiven debt the same as income. This means that if a borrower normally makes $30,000 per year and they have $100,000 of federal student loans forgiven, the year the loans are forgiven the IRS will tax them as though they earned $130,000.
Any borrower in this situation would be wise to start setting aside money now for this eventual massive tax bill.[Further Reading: Preparing for the Student Loan Tax Bomb]
Think About Public Service Employment
The one big exception to the student loan forgiveness tax rule is Public Service Loan Forgiveness. Under PSLF, borrowers can have their student loans forgiven after ten years of certified payments. PSLF forgiven debt is not treated as income by the IRS.
While there are many hoops to jump through to qualify for PSLF, the benefits can be massive. For borrowers with large amounts of federal debt, a switch to a public service employer could result in huge savings. This option can make the comparatively lower government and non-profit salaries more attractive to student loan borrowers.
Having a large student loan balance that is going in the wrong direction is a scary proposition. Short of earning more money, borrowers can’t do much to address the problem immediately. However, some steps can be taken to minimize the spiral out of control and eventually wipe the debt off the books.