A recent article by Forbes rounds up the current state of the union with regards to student loan debt and it’s quite amazing. According to their sources, the current student debt loan balance for Americans is a whopping $1.6 trillion across roughly 45 million borrowers. The average debt balance is $32,000, which might make you feel much better or much worse about yours but don’t worry! After this article you should have a better idea as to what options are available for your future.
For those who have not taken on this type of debt and might be thinking about it for yourself or your children in the future, there is one important rule to consider before taking on education debt. We typically advise clients not to take on more in student debt than they expect to earn in their first year after school. This will help set you up for success when it comes to repaying your loan.
At a high level, there are two types of student loan options: federal and private. Each has unique characteristics that can be valuable for different financial situations. Let’s kick off with federal loans as these are more complicated.
Subsidized vs. Unsubsidized Federal Loans
In the Federal loan arena there are two types of loans, subsidized and unsubsidized (some may refer to these as Stafford loans or Direct Stafford loans, respectively). Subsidized loans have a more favorable loan policy but require you to qualify as your income can’t be too high. The reason these are more favorable is that the loan does not accrue interest until the term is completed (usually when you finish your schooling). The more common unsubsidized loan accrues interest immediately just as any loan would. Take a look at the example to better understand this concept:
Subsidized loan at 6% taking out $25,000 per year:
Unsubsidized loan at 6% taking out $25,000 per year:
As you can see, there is much more interest due for an unsubsidized loan and it’s important to know that even if you’re not paying down the loan while in school. With this type of loan, you can decide to pay the interest each year or wait until you have finished your schooling. If you wait, however, that will be added to the loan amount. In the example above, you would owe $115,000 when you finished school.
Key characteristics of all federal loans
Before we get into private loans there are a few important things to know about federal loans which typically make them better for the borrower over the life of the loan:
- There are certain scenarios or circumstances where you can pause the payments. One great example is COVID-19. During COVID-19, all federal loan payments have been suspended for up to 6 months. There can be other, less wide-sweeping reasons to pause payments that you may qualify for if you are in a short-term financial bind. Interest may accrue during this period of paused payments, but you have an option to not pay temporarily.
- Interest rates are fixed for the life of the loan. This can be a pro or a con depending on your credit score, but generally federal loan interest rates are lower than you might get from a private loan at the time you take out your loan (think young college kid with limited income and no credit history).
- There is an option for “loan forgiveness.” In certain circumstances, you can qualify for a loan that will require regular payments for a certain number of years, and then the outstanding balance will be forgiven at the end of that period. The payments may be adjusted annually based on your income. If you start to make more money, your payments will increase.
So how does this compare to a private loan? Private loans are held through a private company like a bank (example, First Republic Bank) or more recently, digital providers like SoFI. These institutions don’t have tax dollars supporting their business and therefore there is less wiggle room if things get tough. If for any reason you need to pause payments temporarily because you've lost your job or there is a global pandemic, private loan providers will have no empathy. For some, this alone is a reason to avoid privatizing your student loans.
Private loans tie your interest rate to your credit history just as any line of credit (credit card, mortgage, car loan) would be. This can be a very positive thing if you already have student loans and applied for them when you didn't have great credit. Your credit score may have improved and this will give you an opportunity to drop your interest rate. In most cases, however, private loans offer variable interest rates, which means that the interest rate can change over time. It can go up or down so there is more risk associated with a variable rate.
We mentioned above that there are certain circumstances where your federal loans can actually be forgiven by the government. That’s right, one day they might just disappear! Let’s unpack this a bit more.
The first thing to note is that as with any government regulation/law, this is subject to change. We don’t know for certain that this is going to be around indefinitely and we have seen a very small amount of loans forgiven since this is such a new program. With that said, let’s talk about the options as it stands right now.
There are three major categories of loan forgiveness:
- Career-based repayment: This allows individuals who work in certain fields like public services or teaching to qualify for this program.
- Loan discharge: There are certain circumstances like bankruptcy, disability, or even school closure that would qualify you for this program.
- Income-based: This allows you to pay a certain percentage of your salary each year to the loan and have it forgiven after a certain number of years.
It’s important to note that you will have to submit your income each year and the payment amount will increase or decrease depending on the value of your income. A drastic example would be someone who went to law school. If you spend the first part of your loan years working as a clerk or doing a low-paying internship, your monthly payments may be small, say $200. If you then become a lawyer and jump your salary, your payments could jump to $1000 per month. That said, this is only a percentage of your income so in theory, your new higher income would be able to cover the payments.
Should you refinance?
The reason for refinancing your student loans is if you're moving from federal to private or private to private. The primary goal of refinancing is to lower your payments either immediately or for the life of the loan.
When you are considering refinancing from federal to private you should note if you are in any form of loan forgiveness. If, based on your career path (think lower-paying jobs or inconsistent jobs), you feel you might not be able to pay the loan back in full or at any point, you should stay in the federal program. If your income is going up and you can get a better interest rate through a private loan, this may be the better option.
Student loans can help you advance your career, and ultimately your salary, so there are great reasons to take on that debt. It’s important to evaluate what type of loan and how much is right for your future. If you want to discuss your options, contact your Origin Planner.