4 federal loan payoff plans

Four Strategies to Pay Off Federal Student Loans

Michael Lux Blog, Strategy, Student Loans 2 Comments

Elimination of federal student loans can be a major challenge.  While the existence of a variety of income-driven repayment plans and loan forgiveness options are an asset, they also make forming a repayment strategy more difficult.

Today we will discuss the four most common debt elimination strategies and give examples of when each strategy is best utilized.

Strategy #1: Standard Repayment Plan

Most borrowers are automatically enrolled in the 10-year standard repayment plan.  Repaying loans according to this strategy will mean 120 equal payments and the entire student loan will be paid off after 10 years.

The main benefit to this approach is that it is very simple.  When the bill comes in the mail, it gets paid in full each month.  Monthly payments will often be higher than they would be on other repayment plans, but the standard repayment plan ensures debt elimination according to a set schedule.  No math needed or special planning required.

Who this works best for: If you are looking for the most simple and straightforward repayment strategy, look no further.  This approach is also best for people who might struggle with the self-control required for an aggressive repayment strategy.

When not to use this approach: The standard repayment plan is not the most expensive way to pay off student loans, but it isn’t the cheapest either.  Borrowers who use this plan risk unnecessarily spending too much on student loan interest.

Strategy #2: Chasing Student Loan Forgiveness

The two most popular student loan forgiveness program are Public Service Loan Forgiveness and forgiveness coming at the end of an income-driven repayment plan.

Under Public Service Loan Forgiveness, borrowers must make 120 certified payments while working for a public service employer.  There are a number of hoops to jump through to get on the right repayment plan and ensure loans are eligible, but the upside is huge.  After 10 years, borrowers can have their entire remaining federal student loan balance forgiven.

Using an income-driven repayment plan, borrowers are responsible for paying a set percentage of their discretionary income for 20 or 25 years, depending upon the plan selected.  After the 20 or 25 years worth of payments are made, the remaining debt is forgiven.  All borrowers, regardless of occupation or employer are eligible for this program, and those without a job or with a low paying job could qualify for $0 per month payments.  Unlike the Public Service Loan forgiveness program, when the debt is forgiven the IRS treats the forgiven debt as income, so taxes must be paid on it.

Who this works best for: Chasing forgiveness is the best approach for people who make too little to realistically pay off their debt in 10 or even 20 years.

When not to use this approach: Going after student loan forgiveness can actually be the most expensive repayment strategy.  By prolonging payments, the loan generates more interest over the years.  Some borrowers may end up spending more chasing forgiveness than they would have if they just aggressively paid off the debt or repaid under the standard repayment plan.

Strategy #3: Aggressive Loan Repayment

The are several different approaches to aggressively paying off student loans, but the simple version is that borrowers chose to pay off their student loans as fast as possible in order to spend as little as possible on interest.

Common tactics that are used include seeking out minimum payments in order to pay extra towards high interest debt, paying extra each month on the loan with the lowest balance, or refinancing the debt with a private lender to lock in lower interest rates.

The idea behind this strategy is that the sooner the loans are paid off, the less will be spent on interest.  For many, this approach will have the lowest possible cost of repayment.

Who this works best for: This strategy makes sense if repayment of student loans is not a question of if it can be afforded but rather a question of when they will be paid off.  Refinancing can be a risky move because it eliminates federal perks like income-driven repayment plans and loan forgiveness, but borrowers who don’t require these protections can get dramatically lower interest rates.

When not to use this approach: If income stability or future earnings are a concern, it is important to keep federal borrower protections in place as well as having a large emergency fund.

Strategy #4: The Holding Pattern

Borrowers who are not sure which strategy is best can just tread water as they evaluate their options and weigh the various pros and cons.

The best way to do this would be to enroll in an income-driven repayment plan.  Borrowers who ultimately decide to pursue loan forgiveness will be glad this step was already taken.  Opting for an income-driven repayment plan also affords many borrowers the option to set aside money should they decide to aggressively pay off their student loans.

The strategy here is to get started on a repayment plan eligible for forgiveness, but to also set aside money for aggressive repayment at a later date.  This gives borrowers a head start on both routes without committing to anything.  Once it is clear which strategy will be most effective, the borrower can then shift strategies quickly and efficiently.

Who this works best for: This option is excellent for recent graduates unsure of what their long-term earnings will look like.

When not to use this approach: This strategy is a mistake for individuals who are just looking to procrastinate on loan repayment.  Once future earnings and future expenses are fairly predictable, it is time to come up with a long-term plan.

Choosing the Best Strategy

One mistake that too many borrowers make is that they look at next month or next year and they don’t think further down the road.  Low monthly payments are nice, but debt elimination should be the ultimate goal.  This requires running the numbers to calculate total spending when utilizing the various different strategies.  One tool that can be especially useful in this endeavor is the federal student loan repayment estimator.  The repayment estimator will help project monthly payments, payoff time, total spending, and loan forgiveness.  One important detail to note is that it assumes a 5% raise every year.

The biggest mistake a borrower could make is to ignore their student loans and hope for the best.  Programs and strategies are available for both high earners and those struggling each month.  Ignoring federal loans and not putting together a plan will only serve to make things worse and more stressful.

Those who do not know where to start are probably best suited for choosing the holding pattern.  During this time, get familiar with the various repayment plans, refinance options, and overall strategies.  The more learning that takes place, the more clear the ideal route will become.