Developing a Strategy for Handling Student Loan Debt

Our Blog Post today is brought to you by fellow fee-only financial advisor, Gregory A. Johnston of Johnston Investment Counsel. His article discusses how to go about Developing a Strategy for Handling Student Loan Debt.  Gregory A. Johnston, CFA®, CFP®, CPWA®, QPFC, AIF® has over 25 years of investment and comprehensive finanical planning experience. He started Johnston Investment Counsel in 1997 as an independent, fee-only investment management and comprehensive planning firm located in Peoria, Illinois. His clients include individuals, retirement plans, and endowments / foundations.  Enjoy the article.

The amount of student loan debt is a significant issue in the U.S. The cumulative amount of debt is over $1.2 trillion and continues to grow. The burden of student loan payments force many recent graduates to move back home with mom and dad for several years or otherwise impedes traditional household formation activities (buy homes / cars or otherwise reduces financial flexibility).

Many have even wondered if going to college is even worth it. And, perhaps, for the first time in our history, this is a valid question one should consider. There appears to be a shortage of many trade jobs (plumbers, electricians, carpenters) who can make a good living.

There are things one can do before even going to college that can significantly reduce the total cost. The first is to realistically assess what the long-term income prospects are for their chosen degree and field.

If future prospects are financially modest, but are very personally rewarding, that does not imply do not go to college. In this scenario, as well as many others, one should spend considerable effort on trying to reduce the overall cost of college. The key, if future income is modest, is to not go into significant debt to earn your college degree. The cold hard fact is that not all college degrees are valued equally by the “real world”.

Some ways one might consider reducing the total cost of college include:

  • Going to the local junior college and living at home.
  • Cast a wide net in terms of selecting a college. While difficult, do not fall in love with a given school in that you are willing to pay any price. For many, where they go to college is an emotional decision, but the schools treat it as a financial decision. For every dollar they give you in an aid package, that is a dollar that cannot be used for someone else. Be as flexible as possible and play one institution off another.
  • Get good grades. Colleges are interested in getting good rankings which will help them attract good students (and future donors to their endowments). So if you have good grades, they may be willing to provide a better financial aid package. If you have average grades, there is no incentive for the college to invest heavily in you (in terms of financial aid).

So those are some thoughts on reducing the cost before your first day of going to “State U”.

Suffice it to say there are a variety of public and private alternatives for student loans. Because of the flexibility of some repayment options, one may have a preference for federally funded loans (more on this in a moment).

It is very important to read the terms and conditions of the loan so that you understand what you are signing up for. Unless you are totally disabled, student loan debt should be considered not dischargeable in bankruptcy. This simply means borrow what you plan on paying back because you will be paying it back – even if your future wages are garnished.

Loans typically do not require repayment while the student is in college, but the interest accrues and compounds from day one. If you choose, you could pay the interest cost on the loan while the student is still in school. Doing this will reduce the total cost of the loan.

Once the student has graduated, they need to decide how to pay the student loan back. There are a variety of repayment plans. While the following list is not all-inclusive, it provides a range of alternatives:

  • The standard repayment is 10 years. You would make 120 equal payments to discharge the debt. This would more than likely be the highest monthly cost but could be the lowest total loan cost.
  • Repaye. This is generally 10% of your discretionary income.
  • Paye. Generally 10% of discretionary income but never more than the standard 10-year payment plan.
  • Income Based Repayment. 10% of discretionary income for new borrowers after July 1, 2014.

Background information on different repayment plans is available at the Federal Student Aid Office website (https://studentaid.ed.gov/sa/repay-loans/understand/plans/income-driven)

With the income based repayment, your student loan payment increases as your income increases. The income based repayment plans (Repay, Paye and Income Based Repayment) have a repayment period of between 20 and 25 years. The attractive feature of these income based repayment plans is that at the end of the repayment period any outstanding student loan balance is forgiven.

One possible “gotcha” is that any amount forgiven is considered taxable income in the year the loan is forgiven. So if $25,000 of a loan is forgiven, the taxpayer would add $25,000 to their income for that year. It could be a very nasty surprise, but as long as it is known, it can be planned for.

One other factor that should be considered is that adjusted gross income (or a modification of adjusted gross income) is used to determine the amount of loan repayment. If there is a couple that is considering marriage and there is a low and a high-wage individual, it is quite likely that their payment will increase as a result of the high-wage person.

It is important to realize that these programs are for federal loans only. If one consolidates all their loans with a single private company, they will only have the repayment options offered by that private company and, more than likely, no loan forgiveness options.

Another alternative is something known as Public Service Loan Forgiveness (PSLF). This program is usually available to individuals who work for the government or a qualified non-profit. Certain occupations are also targeted such as teachers and medical professionals who agree to work in underserved areas.

In addition to working for a “qualifying firm”, you must make 120 payments before the remainder of the loan will be forgiven. One may want to choose the smallest monthly payment as the remaining balance will be forgiven tax free (unlike the other income based replacement programs).

Today, the financial implications for those going to college are extremely high. There are ways to reduce the overall cost of college, but one needs to plan appropriately and realize that tradeoffs and choices may have to be made.