lower payment strategy

Mailbag: Should I Switch Federal Repayment Plans?

Michael Lux Blog, Lower Payments, Mailbag, Strategy, Student Loans 0 Comments

Making the decision on whether or not to refinance your student loans can be very challenging.  On one hand you have the low interest rates offered by the refinance companies, but you are forced to give up federal perks.  One of our readers, Brad, is currently facing this dilemma.  He has a great job, but also has a lot of federal student debt, so it is a high stakes decision.  If you have a question for the Sherpa, feel free to ask us!

Jeff writes:

Hello Sherpa,

I believe that I read on your site that it is a good idea to get your minimum payments as low as possible.  Say all my loans are on a ten-year term.  If I changed them to 15 years, the minimum payments would be a little lower.  If I throw all this money at my highest interest loan, I would pay fewer total dollars in the long run.  That makes sense.

My first question is will my rates be subject to change?  Typically longer loans have higher rates because you are borrowing the money for a longer amount of time.

My second question is are there any downsides to doing this?  Like will I lose any options in the future by increasing the term of my loans?  They are all federal, I know that refinancing them private would eliminate some of the income driven payment plans. I am not sure if this would have a similar impact.

My third question is what other advice would you give me.  I am posting my loan amounts and rates below.  I know you have a lot of experience in this matter, maybe you see an opportunity for me.

Loan 1  $1,726   3.15%
Loan 2  $0             6.8%
Loan 3  $1,726   3.15%
Loan 4  $0             6.8%
Loan 5  $4,514   3.15%
Loan 6  $0              6.8%
Loan 7  $4,304   3.61%
Loan 8  $4,249   3.61%
Loan 9  $4,385   4.41%
Loan 10 $292     4.41%
Loan 11 $11,067  5.59%
Loan 12 $0            5.84%
Loan 13 $13,476  5.06%

So the first 10 loans are from undergrad.  The last three are from grad school.  While at grad school I took advantage of the extended grace period and hit the high interest loans pretty hard.  However, I ended up with almost $25K more debt from grad school.  My current minimum payment is like $491 per month.  I got married and moved to a dramatically more expensive city.  My wife is a full time grad student so my income is the the only thing we are living on.  I can’t really afford to pay more than the minimum right now.  Thanks to my masters degree, my income will be substantially higher in a few years.  I have already discussed this in depth with my employer and he has verbally committed to bringing me on as a partner once his current partner retires within the next 2-4 years.  He is going to put it in writing soon.  Plus my wife should be able to get a salary between $70 and 100K per year.  It’s just that these next 2 or 3 years will be tight.

I was thinking that moving all my loans to 15 years would lower my payment and let me go after loan 10 because it is almost gone.  Then loan 11 because it has the highest remaining interest rate.  Then 13 the next highest.

Can you think of anything else that I could or should be doing?  I know my highest interest rates are not nearly as bad as a lot of other people, but this is still a lot of money that I am paying here.  Even if it only helps me a little, it would still be a lot in the long run.  Like I already switched to autopay and  that lowered my rates a 1/4 point.

Thank you for any time or advice that you give.  I wish my high school would have had someone sit down with me and explain things the way you do here.  I would have went to a cheaper school for the first couple years then transferred somewhere else to finish.

Thanks again,

Jeff

Advice on Switching Repayment Plans

Before we get into the specifics of Jeff’s questions, we should probably first point out that while we can offer thoughts and suggestions, ultimately, the best solution varies from borrower to borrower.  In Jeff’s case, he may decide that having extra money now is a big priority, and he is willing to spend more over the life of the loan on interest.  Alternatively, he and his wife may say we want to get rid of it as fast as possible and opt for a very aggressive approach.  They may find a middle ground that suits them.

That all being said, we do have some ideas…

Consider an Income-Driven Repayment Plan

Jeff’s plan to switch from the standard 10-year repayment plan to an extended repayment plan will definitely lower the payments on his loans.  However, we should note that there is not a 15-year repayment plan option with federal loans.  You can do a 10-year plan or a 25-year plan, but to pay it off in exactly 15 years, it would require signing up for a 25 year plan and just doing the math to figure out what monthly payment will get it done in 15 years.

Depending upon Jeff’s income, an income-driven plan may be even lower than the extended repayment plan.  The best way to determine what monthly payments would be on various plans is to consult the Department of Education’s Student Loan Repayment Estimator.

There are a number of factors that go into repayment plan selection, such as loan forgiveness eligibility, so it is important to review the differences between the various plans.  For most people, the plan offering the lowest monthly payment is the best option.  This is because it frees up the most cash to pay down the high interest rate loans.  In Jeff’s case, if he was required to pay less towards his loans with a 3.15% interest rate, he could pay more towards the loan with the 5.59% interest rate.  By getting signing up for a plan with lower payments he can pay the exact same amount of money, but pay off his loans faster.

Consequences of Changing Repayment Plans

Jeff is justifiably concerned about interest rates increasing if he switches repayment plans.  If we look at the refinance rates offered by private lenders in 5 year loans compared to 20 year loans, the longer loan has a much higher rate.  Fortunately for Jeff, the interest rates on the federal loans do not change if you opt for a longer repayment plan.

The one consequence of changing repayment plans is that if you only pay the minimum, you will actually spend more in the long run.  The longer the loan lingers, the more you spend in interest.  For the switch to be financially beneficial, it requires the self-control to take the money saved on low-interest loans and apply it towards the high interest loans.  If you cannot do this, it might be best to stick with the 10 year plan.

Other Thoughts

Jeff and his wife seem to have large income increases in the near future.  There is certainly temptation to just lower the minimum and then get serious about the debt when you make more money.  This is definitely a question of personal preference, but until things are set in stone, it is always a good idea to exercise some caution and do what you can now to ensure the future is secure.

The Sherpa Approach

If I was in Jeff’s situation, I’d first take a look at my monthly budget to see how much I can realistically afford to spend to pay down my debt.  Then I’d look into finding the lowest possible monthly payment.  The extra money that I can afford to use to pay down my student loans would probably start with loan 10, then jump to loan 11 like Jeff suggested.  While loan 11 does have the highest interest rate at 5.59%, loan 10 isn’t too far behind at 4.41% and with a tiny balance, loan 10 is low hanging fruit.  I’d take an easy win to start the process.

Some people might consider refinancing their loans with a private lender, but I probably wouldn’t go down that road until I reached to point where I was more certain that I would pay off my loans in full.  A big salary increase or extra income from the wife might be enough to do it, but for now I’d stick with federal loans and federal perks like income-driven repayment plans.  Many of Jeff’s loans are just over 3%, so the risk vs. the reward favors keeping things federal for now.