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Why Lowering Federal Payments to Pay Off Private Loans Can be the Smart Approach

Michael Lux Blog, Strategy 0 Comments

One of the most common student loan repayment strategies is to pay off the highest interest student loan first. But this one size fits all approach isn’t always the best idea.

In many cases, student loan borrowers should focus on paying off their private loans before attacking their federal loans. Borrowers going this route should get the lowest monthly federal payment possible and use the cash freed up to pay down their private loans.

The optimal strategy will depend upon loan balances, interest rates, and the borrower’s employment outlook. In the right circumstances, putting federal student loans on an Income-Driven Repayment Plan or Graduated Extended Repayment Plan can be the right approach. This repayment strategy enables paying extra on private loans and eliminating the private debt first.

What is the advantage of federal loans over private loans?

Private student loans are literally and figuratively unforgiving. They are literally unforgiving because most student loan forgiveness programs do not apply to private loans. They are figuratively unforgiving because repayment plans are strict and offer little help to borrowers who are struggling.

The federal repayment flexibility is part of the reason that students are usually advised to borrow federal loans before resorting to private student loans.

Most borrowers are aware of the Public Service Loan Forgiveness program for federal loans, but there are additional forms of forgiveness. Income-driven repayment plans like IBR, PAYE, and REPAYE offer loan forgiveness in 20 or 25 years. Two decades may seem like a financial eternity, but for borrowers struggling to keep up with their debt, there is a light at the end of the tunnel.

The other advantage of income-driven repayment is that it helps ensure monthly payments will always be manageable. Borrowers are expected to pay based upon what they can afford rather than what they owe. This means that federal borrowers won’t have student loans destroy their credit report if they lose their job or have their salary cut.

Reasons to Pay Off Private Student Loans First

Knocking out private student loans is about protecting the future.

If you work in a field where a long period of unemployment is possible, federal loans are ideal. Private student loans could make a bad situation worse, while federal student loan payments can be lowered to $0 per month until you find a job.

If you think Bernie Sanders or Elizabeth Warren might deliver on their plan to cancel student loans, it makes sense to knock out the private loans first. Both candidates are promising to address both forms of debt, but federal loans could be much easier to forgive, so it is possible that only federal loans are forgiven.

If you might go after student loan forgiveness, focusing on paying off private loans first is a must. Public Service Loan Forgiveness has gotten a lot of bad press lately, but it remains a reasonable debt elimination strategy. Those that work for the government or a non-profit may find that the math says chasing forgiveness is the best route.

Getting Lower Monthly Payments on Federal Loans

Borrowers that opt to attack private student loans first will want to get the lowest possible monthly payment on their federal loans. Borrowers that lower their federal payments by $200 per month should be able to use that $200 per month to pay extra towards their private loans.

Many borrowers will find that an Income-Driven Repayment (IDR) plan yields the lowest monthly payments. Borrowers with larger loan balances and/or smaller incomes will often save significant amounts of money each month on an IDR plan. The idea IDR plan will depend upon the borrower’s income, loan types, and marital status, so it is essential to research IDR options to pick the best plan carefully.

Federal borrowers with higher incomes and smaller federal balances may want to consider the graduated, extended, or graduated extended repayment plans. These plans spread payments out over a longer period and/or start with smaller monthly payments. The downside to these plans is that they do not count towards student loan forgiveness.

One helpful tool for evaluating repayment plan options is the Department of Education’s Repayment Estimator. The Repayment Estimator isn’t a perfect tool, but it does a nice job previewing monthly payments on the various federal repayment plans.

When this Strategy Fails: Low-Interest Private Student Loans

Some borrowers have private student loan interest rates below 3% while they have federal loans at more than double the rate of their private loans. These borrowers may decide that the high interest rates make paying off the federal loans a bigger priority.

The advantage of knocking out the high interest debt first is that it reduces long-term spending on interest. The downside is that the borrower-friendly loans are eliminated while the strict loans remain.

Borrowers considering paying off their federal loans first may find that an alternative strategy works best…

Alternative Strategy: Student Loan Refinancing

Student loan refinancing is a powerful tool in debt elimination because it allows borrowers to get lower interest rates on their student loans.

When loans are refinanced, old high-interest loans are paid in full using a new loan at a lower interest rate. Borrowers with solid credit scores and a decent income can save significant amounts of money by refinancing.

Some borrowers opt to refinance their private loans to the lowest rate possible. This makes eliminating private loans easier because they generate less interest each month.

Other borrowers choose to refinance their federal and private loans. The risk to this approach is that borrowers give up federal perks and flexibility, but for borrowers who know they will pay off all their loans in full, refinancing everything streamlines the process and saves money on interest.

Borrowers looking to refinance should be sure to shop around to find the best deal. Each company offers unique pros and cons.

SoFiLendKeySplash FinancialELFI
Pros:SoFi is the only lender who will help a borrower find a job, and they routinely have the lowest rates offered.LendKey works with a large network of smaller credit unions and banks. As a result, many applicants get the best offer from LendKey.Splash has the best new customer bonus right now, and they have unique 8 and 12 year repayment terms.Because ELFI is backed by a bank rather than investors, ELFI rates tend to stay low and fluctuate less than others.
Cons:SoFi has grown into a large company offering mortgages, personal loans, and investment services. They no longer focus entirely on student loan refinancing.Going the LendKey route does require working with a local bank or credit union. For many, this is a plus, but it is an extra step.Splash is a newer lender and the longest length loan is 15 years instead of the industry standard 20.ELFI is one of the newest lenders in the marketplace. As a result we have limited head to head information.
Bonus:
$150
$150
Up to $500
$150

Final Thoughts on Attacking Private Debt First

Some debts are worse than others.

Credit card debt is worse than mortgage debt, so consumers normally focus on eliminating their credit card debt before trying to pay off their house in full.

When it comes to student loans, many borrowers try to pay off the highest interest rate loan first. However, this is not always the ideal approach. For some borrowers, federal student loans are better because of the perks and protections they carry. These borrowers may want to pay off their private student loans first.

Ultimately, the best approach is to make a plan designed to fit your specific needs. That could mean switching federal repayment plans to the lowest monthly payment to pay down private loans.

The key is to understand the pros and cons of each loan and to eliminate the least desirable loans first.