You’re a responsible student loan borrower, taking out only what you need and paying your bills on time every month.
But with so many changes to student loans in recent years (and so many details in the fine print), it’s easy to overlook some of these unexpected costs.
Save yourself the surprise – and the money – by considering these issues (Originally provided by Janet Al-Saad of the Five Ten Twenty Club).
Careful With Interest Rates
Remember that your interest rate is one of the most important factors in your overall cost of borrowing, along with the amount borrowed and your repayment time. Doing anything you can to reduce your interest rates, then, should be a priority.
This means signing up for autopay and making your payments on time, since may lender will offer deductions of 0.25% or more for each of these. In some cases, you might be able to save over 1% on your total interest rate.
Keep in mind that consolidation has its costs, too: Your loans’ average interest rate is rounded upwards when consolidated. If you have a substantial loan balance, the extra tenths of a percentage point can add up to thousands in extra payment costs.
Is Your Payment Plan Costing You Too Much?
If you’ve got sizeable federal student loans, your choice of repayment plan could cost you thousands. For borrowers with the heaviest burdens relative to their incomes, it could be hundreds of thousands. How is this possible? Simple. When federal student loan borrowers face financial need, they usually turn to income-sensitive programs, such as Income Based Repayment (IBR) and Pay As You Earn (PAYE), which cap your payments at 15 or 10% of your disposable income, respectively.
Under IBR, you’re required to make 25 years of payments; any remaining balance is then forgiven. PAYE requires 20 years of on-time payments prior to forgiveness. The difference in repayment terms between IBR and PAYE doesn’t seem that big at first glance. But look closer and here’s what you’ll find.
Using the Repayment Estimator at Studentloans.gov, we find that someone who borrowed $120,000 at an average rate of 7.3%, but only has a starting salary of $60,000 would pay about $150,000 over the life of the loan under PAYE.
But under IBR, that person would pay about $287,000. That’s a whopping $137,000 more! And this doesn’t even account for the lost gains from diverting money that could’ve been used to invest, buy a house or save for retirement to extra student loan payments, instead.
So, why isn’t everyone on PAYE, instead of IBR? Currently, the program is limited to individuals who meet certain qualifications; only people without federal loans issued before October of 2007 qualify, for example. Check with your lender to see how and if you qualify.
Heed The Tax Man
Student loan repayment doesn’t come without some unexpected tax consequences, either. Many people expect to be able to deduct student loan payments from their taxes. But this deduction of up to $2,500 only applies to individuals with Modified Adjusted Gross Incomes of under $75,000. For married couples filing jointly, an income threshold of $155,000 applies.
But there’s another potentially (much) bigger tax issue federal borrowers should understand: The IBR and PAYE tax bombs. Remember the loan forgiveness we discussed above? If, after 20 or 25 years of payments on PAYE or IBR, respectively, you have the remaining loan balance forgiven, you’re nonetheless liable for the tax bill. That’s right – any amount forgiven is treated as income in that year, and taxed accordingly.
The hypothetical PAYE borrower above, for example, would owe taxes on a loan forgiveness balance of $144,555. On IBR, he would owe $0, since he would’ve been making larger payments (and for longer).
Although there has been some lawmaker discussion regarding modifying or even removing the tax bomb, the issue is far from settled, and as it currently stands, is very much real. Consider the impact of any potential “tax bomb” when comparing repayment plans.
In the example above, the borrower will still likely come out ahead by choosing PAYE over IBR, but the difference may be smaller if the tax bomb hits. Finally, remember that changes to student loan programs can occur at any time.
Recent budget proposals have called for a capping of interest rates, public sector loan forgiveness, and other changes which could impact you directly. Stay abreast of changes – and their impact on your pocketbook – by staying in touch with your lender.
“Are Your Student Loans Costing You More Than You Think?” was originally provided by Janet Al-Saad of the Five Ten Twenty Club.