In Part 1 we discussed how to make wise decisions before taking on law school debt. Now we will discuss two of the most significant decisions for graduates: Should you consider income-based repayment or refinance your loans?
Some applicants, students, and recent graduates have heard about income-driven repayment plans and consider that a cure-all for any concerns about debt. Income-driven repayment can be a good option for some graduates, but law school debtors need to know the risks involved.
For federal loans (as opposed to loans from private lenders) graduates usually have the option to use an income-driven repayment plan. There are a variety of income-based repayment plans. The details are different, but the gist is the same. Instead of paying a set amount monthly, you pay a percentage of your income. The percentage is calculated based on differing formulas for each type of plan and can vary based on other socio-economic circumstances, like family size. This can reduce your monthly payment below what you would pay under a standard repayment plan.
The immediate financial flexibility of income-driven repayment plans is appealing. But it comes with drawbacks. Because you are paying below what a standard repayment plan requires, you are likely accruing additional interest and increasing the total amount owed.
Take for example, this story shared on Twitter by a former student who has paid on time every month and now owes nearly $70,000 more in student loans due to unpaid interest.
That increased amount is particularly scary because, in certain situations, that additional unpaid interest could become part of the principal owed on the loan, an event called capitalization. After capitalization, interest is calculated off the combined amount of the original principal and plus the unpaid interest. (Before, the unpaid interest was kept separate, and no interest was charged on it.)
So why does anyone do an income-driven repayment plan if you are unlikely to ever pay off loans under them? Because income-driven repayment plans may come with potential loan forgiveness too. Again, the details vary by plan, but an individual can receive loan forgiveness after 20 or 25 years. Or, for those who are in certain qualifying public interest jobs, an individual can participate in the Public Service Loan Forgiveness program, which forgives loans after 10 years. Those who qualify for the Public Service Loan Forgiveness program can save thousands of dollars (potentially six figures’ worth) in overall loan payments.
So, if there’s loan forgiveness, why would anyone not do an income-driven repayment plan? A few reasons. First, some may face a “tax bomb.” A tax bomb refers to the fact that when loans are forgiven, the forgiven amount is treated as income, which has to be taxed. (This is not a problem, however, for those participating in the Public Service Loan Forgiveness program, which has specifically made the loan forgiveness non-taxable.)
Unlike income from an employer, no one withholds taxes for loan forgiveness. So debtors will owe significant amount of taxes for the forgiveness. In fact, the amount owed will usually be worse the lower someone’s income is, because that means less interest has been paid and more has to be forgiven in the end.
Second, in some circumstances, you may pay more in the long run. For those going to non-BigLaw jobs, income is likely to risk steadily over time. So the amount paid under an income-driven repayment plan will also grow. Worse, capitalization can inflict additional interest and raise the maximum amount you are required to pay under the income-driven repayment plan. And if you ever move to a significantly higher paying job, you may have to pay the standard repayment rate—without any of the benefits of paying it off sooner.
Third, loan forgiveness is subject to political whims. As recently reported, the current administration is considering cuts to the loan forgiveness programs. There is always a chance that what may be available today will be taken away tomorrow without any promise that borrowers won’t be left holding the bag.
Similarly, the process for receiving forgiveness is notoriously opaque, posing a risk someone believes they’ll receive forgiveness, only to find out a bureaucratic misstep has cost them thousands of dollars.
Now these risks are just that: risks. Income-drive repayment plans still make sense for many borrowers. But they are not a guarantee, as some treat them.
Another option graduates should consider is privately refinancing their loans. Refinancing means a private lender pays off your loans on your behalf and you now pay the private lender. Private lenders will generally give a lower interest rate than the federal rate. How much better the rate is depends on a lot of variables: your credit history, the term (length) of the loan, whether you want a fixed (set for the life of the loan) or variable (subject to change based on market rates) interest rates.
Generally, the biggest drop in interest rate will come if you reduce the term of the loan. You can reduce your interest rate by as much as five percentage points. That may not sound like a big deal. But if you switch from a 25-year loan at 6.58% (the average federal rate) to a 5-year loan at 3%, you will save over $140,000 in interest over the life of the loan.
Of course, you will have to pay much more per month (about $1,700 more). While the increased monthly payments are difficult, those savings are huge. Even if you keep a 25-year term, if you can save one percentage point, you will save about $30,000 over the life of the loan. Refinancing for a lower interest rate can have huge savings.
Refinancing has its tradeoffs. The biggest loss is that you lose out on the opportunity to participate in the loan forgiveness programs. Similarly, federal loans offer significant protections for financial hardships. While private lenders offer some protections, they are not as expansive.
Finally, graduates who have spouses or children should check what kind of protections lenders give upon the death of the borrower. The federal government generally forgives loans upon death, while private lenders’ rules vary significantly.
Income-driven repayment and privately refinancing benefit different segments of borrowers. Low-income individuals will generally benefit from (and possibly depend on) income-driven repayment to make monthly finances work. Refinancing allows individuals with higher incomes to pay their loans off quicker and save significant money in the long run. Those in between should become familiar with the options they have; the difference can be thousands of dollars.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Bryan Gividen is an attorney Vinson & Elkins LLP in Dallas where he focuses on shareholder and appellate litigation. He regularly tweets advice for law students, recent graduates, and anyone else willing to listen at @BryanGividen.