Government Statistics Analyzed: Most People are on the Wrong Repayment Plan

Michael Lux Blog, Lower Payments, News, Student Loans 10 Comments

This week the Consumer Finance Protection Bureau, released statistics on student loan borrower habits.  The good news here is that it is nice to see the federal government showing some interest in those of us who currently owe them over a trillion dollars.  The bad news is that their figures show that the majority of people are making poor repayment plan decisions.

Some Shocking Numbers

Pay As You Earn repayment plan (PAYE) is by far the best federal repayment plan.  For those who do not qualify, the next best repayment plan will almost always be Income Based Repayment (IBR).  Looking at the CFPB statistics, we see that only 6.3% of people who are repaying their loans are taking advantage of these great plans.  Here is the really shocking number: for every one person who is on PAYE or IBR, there are SIX people who are in default on their federal loan.

This statistic is mind blowing for a number of reasons.  First of all, defaulting on federal student loans has devastating consequences.  Your paychecks and tax refund can be garnished without any court order, and your credit is absolutely destroyed.  Secondly, signing up for IBR or PAYE means that the very most you will have to pay for your student loans is 15% of your discretionary income.  That means if you are broke and with no income, signing up for one of these plans would help you avoid default and get you one step closer to having your loans forgiven.

You are definitely on the wrong plan if…

If you are currently on an extended or graduated repayment plan, it is time to make a change.  Prior to 2007 the extended and graduated repayment plans offered the lowest monthly payments.  With the creation of the IBR plan, this all changed.

Under IBR borrowers are expected to pay 15% of their discretionary income and nothing more.  If these borrowers make timely payments for 25 years, their remaining debt is forgiven.  Compare that to the extended repayment plan.  Again, it takes 25 years, but your monthly payment does not consider how much you make each month.  If you are struggling to make your payments, the extended play will help, but only to a certain extent.

Do the math.  If your goal is to have your loans paid off in 25 years, which plan makes more sense?  The one that takes a certain percentage of your income and nothing more, or the one with the rigid schedule an no flexibility?

What about the interest?

If you are concerned about the interest on your loan growing with each month that you are making the minimum payment, then your thinking is on the right track.  If you pay only the minimum, you are insuring that you will be taking a long time to pay back your loans and in the long run you will pay much more.  So why am I insisting that IBR and PAYE are better options?  There are two major reasons: flexibility and forgiveness.

If you sign up for a repayment plan that is based upon your income, you are not required to pay the minimum each month.  In fact, if you are smart you will take a hard look at your finances and answer the following question: Will I pay more if I make the minimum payment for the life of the loan or will I pay more if I pay as much as I can each month?

If student loan forgiveness is in your future, then there isn’t much of an incentive to pay more than the minimum.  It just reduces how much of your loan will be forgiven.  However, if you will pay off the loan before forgiveness kicks in, it makes more sense to pay as much as you can each month.  (Important Note: Remember, there are tax consequences to loan forgiveness, and planning on the government forgiving your loans can be risky, so proceed with caution.)

Even if you will be paying as much as you can each month, Income based plans provide flexibility to pay only what you can afford when the budget is tight (such as during the holidays or when you have unexpected expenses) and you can pay extra when you have extra.  Plus, by doing IBR and PAYE, you guarantee that you won’t be paying off loans the rest of your life.

Three Examples

To understand which approach is best for you, let’s compare three recent grads.  Recent Grad One just got out of medical school, will be starting an internship paying 35k a year, and has 100k in federal student loan debt.  Recent Grad Two also has 100k in debt and will be making 35k a year but this grad will work as a school teacher.  Recent Grad Three also has 100k in debt, will be making 35k a year, but is working as a supervisor at the local factory.  How should these three people handle their debt?

The Doctor

Our newly minted MD will be starting an internship.  For the very near future funds will be tight.  Signing up for PAYE or IBR is definitely the way to go, because that will make the 35k a year go the furthest.  Because the long term earning outlook for the MD is pretty good, it would be reasonable to expect that 10 to 15% of these earnings will pay off this loan within about 15 years.  With this being the case, paying the minimum and waiting for student loan forgiveness wouldn’t make much sense.  My advice to this new MD: standard repayment or even graduated repayment could result in crushing monthly payments, and right now you cannot afford that.  If this person were to sign up for extended repayment, he or she would pay much more than necessary over the life of the loan.  Instead, sign up for IBR or PAYE right away, but realize that eventually you will pay off this entire loan.  Don’t just pay the minimum, because the more you can put towards the loan today, the less you will pay in the long run.

The Teacher

Our new teacher definitely picked the right occupation for student loan repayment.  Working as a teacher qualifies for public service loan forgiveness.  The teacher will have to make 10 years worth of certified student loan payments on an IBR or PAYE plan, and the remainder of the loans will be discharged.  For our teacher, paying the minimum is definitely the way to go.  Seeing the interest add up is scary, but if you are certain that the loan will be forgiven in the near future, there is no point in paying extra.  All you will be doing is reducing the benefit of your student loan forgiveness.  Extended repayment would be a terrible option for this person because payments made under this plan do not qualify for public service forgiveness.

The Factory Supervisor

This person will have the toughest decision.  Loan forgiveness for a private sector job of this nature is at least 20 years away under the PAYE (and 25 under IBR).  Depending upon monthly expenses, other debt, etc., it is not immediately clear whether or not this individual will better off paying off the loan as soon as possible or by working towards forgiveness.  As a result, the best approach is not readily apparent.  In that case, the smartest route would still be to sign up for IBR or PAYE, but instead of just paying the minimum pay off as much as possible.  Each year re-evaluate your finances and decide upon the best plan.

The Bottom Line

There are many federal student loan repayment plans, and they are not created equal.  Over the years, new improved plans have been added, but the less beneficial outdated plans remain.  Don’t make the mistake of getting stuck on an old repayment plan when a phone call and some paperwork could make your life much easier.  Learn all of your options and pick the one that is best for you.

What repayment plan are you on?  What advice do you have for people trying to pick a loan?  What are your thoughts on these shocking statistics?