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So You Have Student Loans. Now What?

by | Mar 7, 2019 | Debt

Do you have student loans that you’re trying to repay? You’re not alone. As of December 2018, total student loans outstanding reached $1.57 trillion. Yes, TRILLION. To put this into context, there is $1.0 trillion of credit card debt outstanding and $1.2 trillion of auto loans.

You have to be smart when dealing with student loans and paying them off. A manageable debt problem can become unmanageable if you’re not careful.

Today I want to highlight some things you need to keep in mind when it comes to student loans. In coming weeks, I’m going to tackle student loan repayment options and loan forgiveness. But before you do that, you must know what you’re dealing with.

[Parents: if you have kids that will go to college one day, don’t skip this post. It’s for you as well. You need to fully understand what can happen if you rely on student loans to send them to college.]

#1: Student Loans Don’t Just “Go Away”

10 short years ago we went through the Great Recession. As job losses piled up, so did the number of people that couldn’t make their mortgage or credit card payments. So they “tossed the keys” back and walked away.

With most types of debt, if things get really bad you can “walk away.” Bankruptcy is the most common option. But there are other ways of “walking away” that result in a reduced loan amount.

Of course, you run the risk of ruining your credit for 7+ years. It’s also very expensive to declare bankruptcy. But the point is that there’s usually an “out” if your mortgage/credit card/auto loan debt becomes too much of a burden.

That’s NOT the case with student loans.

There are only 4 ways to get rid of student loans:

  • Pay them back in full
  • Have them forgiven
  • Become disabled
  • Die

If you have a crushing student loan burden, your options to “get rid” of them are limited and rather unattractive (especially #3 and #4!)

This is the first factor you need to drill into your head: There is no magic wand to make student loans go away. You have to take repayment of these student loans very seriously or they can dog you for the rest of your life.

#2: Federal Loans Are More Flexible Than Private Student Loans, but Not a Panacea

Federal and Private student loans are extremely difficult to get rid of short of paying them off. But Federal student loans have some features which make them easier to manage if you experience difficulty.

First, Federal student loans will be discharged if you become disabled or die. Private student loans won’t let you off the hook if you’re disabled. And many private student loan lenders will still want their money even if you die.

Secondly, Federal student loans provide payment flexibility in case you run into a financial hardship. This is often referred to as “economic hardship relief.” This gives you temporary relief from having to make payments if you’re going through a rough patch. Of course, there’s a cost to this. But at least you have the option. Private student loans are much less flexible working with you if you run into hardship.

Third, Federal student loans offer repayment plans that allow for lower monthly payments. These are called “income-based” repayment plans. Here, your monthly payment is based on what you can afford. This results in a payment that’s lower than a Standard 10-year repayment.

Yet as we’ll see, these repayment plans aren’t a panacea. But at least you have the option with Federal loans. With private loans, you don’t have income-based repayment options.

Fourth, Federal loans offer chances at loan forgiveness. After making payments for 10, 20, or 25 years (depending on the program) the government will “forgive” the debt. Written off…gone for good! There are tax consequences to consider with loan forgiveness. But private student loans don’t offer any sort of loan forgiveness.

#3 Income-based Repayment Plans May Not “Repay” Anything!

Income-based repayment plans can offer flexibility to a borrower struggling to make payments. But they can also be one of the most dangerous financial mistakes you can make if you’re not careful.

These plans promise “affordable payments.” That sounds attractive enough. But in a lot of cases, the trade-off to receive these lower payments is that the amount you owe GROWS every month. After many years, you might end up owning a lot more than when you started!!

Here’s an example of a hypothetical borrower looking at her repayment options:

  • $100,000 of Federal student loans
  • 6.0% interest rate on the student loans
  • $55,000 family income per year
  • Family of 4

The Standard 10-year repayment plan (black line), works like any other loan. You borrow $X at X interest rate and have to pay the loan back in X years. In the example here, the monthly payment would be $1,110 per month.

For a family of 4 earning $55,000 a year, a $1,110 per month student loan payment is going to be a very difficult nut to swallow. Not much cash is left over each month after paying a mortgage, car payments, food, and clothing!

The Federal government created Income-based Repayment plans to “help” borrowers with lower monthly payment options. As the name implies, payments are based on your income. The three income-based repayment plans are represented by the lines IBR, PAYE, REPAYE.

Under these plans, the monthly payment for this family of 4 falls to $136-204 per month depending on the plan. That’s a heck of a lot better than $1,110 a month!

But here’s the big problem. The monthly payment is anywhere from $136-204. Yet the monthly interest cost on these loans is $500/month [$100,000 x 6% / 12 months]. Because the payment is lower than the monthly interest cost, the difference is ADDED to your loan.

In the example above, after 20-25 years the original $100,000 loan has now ballooned into a loan size of $150,000-180,000!! So you never actually “repaid” anything.

That’s what we in the biz call “negative amortization” and neg-am is the mortal enemy of any consumer borrower!

Takeaways

If you already have student loans, the point I want you to take away from this post is this: You have to take repayment of these loans seriously. There’s no magic wand to make them go away. And if you’re not careful, a manageable problem can become a much bigger one.

So if this is you, please draw up a detailed strategy to get rid of your loans. You can either repay them or try to get them forgiven. I’ll be touching on loan forgiveness in upcoming posts.

For parents wanting to send their kids to college, let this post be a “warning shot.” Don’t rely on a strategy of taking out student loans to send your kid to school. Doing so can put them and/or you in an unmanageable debt situation when they’re done with school.

I know it sounds crazy, but you should get to work on college planning for your child as early as 7th or 8th grade. Don’t laugh. The sooner you start strategizing, the better off you and your child will be.

Upcoming posts will touch on other student loan topics. I’ll do a deeper dive into income-based repayment plans and also look loan forgiveness programs. If you want to receive these posts, click “Sign Up” below to get on my email list.

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