We’ve looked at home mortgages. We’ve looked at credit card debt. Student Loans don’t look all that different. You borrow a large sum of money, and then you pay back the money plus a lot of interest. Student loans are just a different version of this: The payoff period is usually 10 years, and so you end up paying much less interest than with a 30-year mortgage.
One downside of student loans: They charge an origination fee, which right now is 1.059%. If you borrow $1,000 you will only get $989.41. The rest ($10.59) is a fee. Some mortgages have origination fees, but not all do.
There are lots of types of student loans. I’m far from the expert here, and so I won’t cover them all. I want to focus on one type of loan: Direct Subsidized Federal Student loans, which are awarded by the US Department of Education.
“Subsidized” is an important word here. There are also Unsubsidized student loans. With a subsidized loan, you don’t have to pay interest while you’re still in school. In effect, the interest is 0% while you’re in school.
With an unsubsidized loan, you also don’t have to make payments while you’re in school, but interest is being added to your total balance. You borrow $20,000 but by the time you start paying off the loan, the balance could be $25,000 or more. The interest-rate subsidy on a subsidized loan is a nice perk.
There are also other perks. Interest rates for the Federal loans are often lower than those you could qualify for with a loan from a private company (called a private loan). And, you may also qualify for payment forgiveness with a Federal loan, under certain circumstances. We’ll get there in a minute.
Here’s a great article in the Wall Street Journal: The Pros and Cons of Federal vs. Private Student Loans. You may not be able to read it because of the Wall Street Journal paywall. Here’s a key quote from the article: “You should never replace a federal loan with a private student loan.” The Federal Loan provides a lot of nice benefits.
Repayment Options for Federal Subsidized Student Loans
Once you are out of school and it’s time to start making payments on your loan, you have some options for the payment plans. Let’s take a look at the options, starting with the default option, called the Standard Plan.
For all of these, we’re going to use these assumptions:
You have a total balance of $20,000 in subsidized loans. You can’t borrow this much all at once with a subsidized loan; the limits are between $3,500 and $5,500 per year. After that you need to use different kinds of loans.
The interest rate on your loans is 4.53%. That was the rate for the 2019-2020 school year.
Your income after graduation is $30,000 a year, you live in Alabama, and you have no spouse or children. Okay, I know this applies to none of you. But the income-based repayment plans use your income and personal status to calculate payments.
The “Standard Plan” makes you pay off your loan in 10 years. This is exactly the same as taking out a 10-year mortgage for $20,000 with an interest rate of 4.53%. Well, except you don’t have to start paying back until after you graduate.
Try to make a spreadsheet yourself before watching me do it below. You’ll want 120 months (10 years) of payments. Monthly interest will be 4.53% divided by 12. And then change your fixed payment amount until the balance goes from $20,000 to $0 after 120 months.
Ready? Here’s how I did it:
I started my month numbers in row 3 instead of row 2; this let me start with my $20,000 loan balance in month 0, and then not make a payment until month 1. It doesn’t matter that much; I could have put the $20,000 in month 1 and gotten almost the exact same answer. I’d have to think about which one is more accurate.
Now just add the interest each month and subtract your payment. I started with a total guess of a $500 monthly payment, which it turns out is way too high:
I’m going to copy the final balance up to a cell near the top, so I can quickly see how that value changes as I change the monthly payment:
So $208 a month, or maybe a touch less. $207.57 is the closest I could get, but our math isn’t that precise. That’s not too bad; multiply that by 120 and you’ve paid a total of $24,908.40 on your $20,000 balance. Less than $5,000 in interest! And notice that even in the first month, something like 64% of your payment goes toward the principal (Our payment is $207.57, and $75.50 of that goes toward interest.) That’s the benefit of a short 10-year payoff plan and a pretty low interest rate.
Well, 10 years may not seem short when you’re the one making 120 payments, but it is short compared to a 30-year mortgage, at least!
Happily, our calculation matches the government’s figures exactly:
That’s from the nice (but a little complicated) loan simulator provided by the Federal Government.
We used the default option (The Standard Plan), which may not be the best option for you. Let’s look at a few more:
Graduated Repayment Option for Student Loan Debt
I don’t love this one. All it does is lower your payments early in the loan, and increase them later in the loan. Lower payments at first means more interest accruing, and a higher total amount you have to pay:
I’m not going to do the spreadsheet for this one, but you could try to estimate. I don’t know the formula for how much your payments increase; I just have the graph:
The payments increase every 2 years, and it looks like the increases are smaller at the beginning and larger at the end. I was able to get really close by having the payment increase by 31.5% every 2 years. So the payment goes from $117 in years 1 and 2 to $153.86 in years 3 and 4. And then to $202.32 for years 5 and 6. And so on.
If you need to lower your payments early on, then this is one option. But I think there is a much much much much better option to consider.
Income-Based Repayment of student loans: IBR
Let me start with the punchline here. Remember that you’re a single person in Alabama making $30,000 a year. Look at your payoff numbers:
What’s going on here? Our total payments under the Standard Plan were $24,908. How are you paying a bit less on your loan here but taking 20 years to do it instead of 10? The answer starts with the fact that the amount you pay is now based on your income. And that amount the government thinks you can pay is often less than the $208 dollars a month you need to pay in order to pay off the loan after 10 years.
Here, you’re paying between $91 and $113 a month. That’s about half of what you’d need to pay to get that loan down to 0 after 10 years. Here’s the key sentence: Any balance left after 20 years is waived. Gone. Here, $10,593 is forgiven.
Sadly, you will have to pay taxes on the forgiven amount. Still, you’re saving real money. Let’s lower your income to $20,000 a year:
You would pay $10 a month for the first 3 years and then … nothing else. Zero. The loan would continue accruing interest, and so your loan balance goes up and up. It gets to $37,760 and then … it disappears.
Now, you have to be very very careful here. If you suddenly get a good paying job in the year 2036, you’d need to start paying off your now large student loan balance. Even if your income slowly rises over time, you could have to pay more and more each year.
On the other hand, if you have children, the amount you would be expected to repay each year goes down.
You have to re-file each year with your income and family situation. So you’re filing 20 times with your status. That’s a hassle. Still, according to debt.org, “The Income-Based Repayment Plan, one of four debt-relief programs instituted by the federal government, might be the most attractive choice for the 73% of graduates in the Class of 2017 who left school with student loan debt.”
PAYE? REPAYE? IBR?
PAYE stands for Pay As you Earn. REPAYE is a new version of PAYE. These are also income-based payment plans that can look almost identical to the income-based option we looked at above. In fact, they are exactly identical for our sample Alabama person:
There are slight differences in the calculation, as you can see from this table:
Note that the first three all say “Generally 10 percent of your discretionary income.” You’ll have to play around with the loan simulator to see if there are any differences for your scenario. Or any future scenarios you can imagine.
PSLF: Forget about Forgiveness
Let’s complicate things one last time. If you’re in one of the income based repayment plans above, you could also qualify for PSLF, which stands for Public Service Loan Forgiveness. The idea here is that if you work in a public service field like government or education, you could get your loan wiped out in 10 years instead of 20.
You have to apply for PSLF after making payments for 10 years. The program started in 2007, and so the first people became eligible at the end of 2017.
Sadly, almost no one is getting approved:
Out of 174,495 PSLF applications submitted and processed to date, the Department of Education approved 3,174. This represents a 1.8% approval rate — slightly better than the initial statistics, but still astonishingly low.
Some of those people probably didn’t follow all of the rules, like being in an income-based repayment plan. But someone people look like they are being rejected for no good reason. Until something changes, I wouldn’t count on this working for you.