The Dark Side of Student Loan Repayment Plans

I wiped away the water that had splashed on my face during the final play of the high school water polo game that I was scoring. Daniel, clad in his white referee uniform, walked to the table with a big grin on his face. “Did I tell you I was accepted to international business school in Japan?” he asked. I congratulated him, and he told me about the program. Because the program sounded expensive, I asked if he would have to take on much debt to pay for it. He shrugged his shoulders and said he would be taking out about $25,000 for the two years of study. “Everybody graduates with debt these days,” he rationalized.

He was almost right. Seven in ten graduating seniors in the class of 2014 had student loan debt with an average balance of nearly $29,000. The class of 2015 may have racked up as much as $35,000 according to data by Mark Kantrowitz, publisher at Edvisors. Student loan debt in the U.S. has risen to $1.3 trillion as of the end of 2015.

In response to the growing student debt problem, legislation (enacted in 2010 and 2012, and further updated in 2014) created income based repayment plans. These plans capped payments at 10 percent of discretionary income and extended the repayment time to 20 years for undergraduate debt (25 years if graduate school debt is included) from the standard ten-year repayment plan. If any part of the debt remains unpaid at the end of the new repayment period, it would be forgiven. With these new repayment plans, college graduates at least have some hope of being able to move out of their parents’ homes.

Income based repayment plans can substantially lower monthly payments, but they have a dark side for those whose situations don’t work out as planned. If your income is low, your required payments, as determined by the income calculation, may be less than the interest on the loan. The amount of interest that you don’t pay is capitalized, which means it is tacked on to your loan as additional debt. As a result, your loan is growing, not declining, even as you make payments. If you are out of work or return to school and are therefore not required to make payments, your loans continue to grow by the amount of the annual interest.

No problem you say. Whatever is left over after 20 years is forgiven, right? Yes, that is true. However, you may not want to be forgiven in this way. Any forgiven balance on your loan becomes taxable income in the year the debt is cancelled under Section 61(a)(12) of the Internal Revenue Code. There is an exception for loan programs where the loan is forgiven after working for the government or for a non-profit for ten years. For any other student loan, having any part of the loan forgiven can be a serious tax burden for you. Think about it. Your income in that year will be much higher than your usual income, but you will not have any extra cash flow with which to pay the taxes.

Minimizing Student Loans

Taking on debt, including student loan debt, puts your financial security at risk. The payments crowd out other uses for your money. Even though the cost of college is astronomical, there are ways to minimize your use of student loans.

Attend an in-state public school. Most occupations pay the same whether you graduate from a private school or a public institution, but the cost to attend a private school is substantially more.

Live at home. Room and board can cost more than $40,000 over four years. Just saving that amount alone would eliminate the average student loan debt.

Consider an accelerated degree program. Many schools are offering tracks of study that will allow you to complete a bachelor’s degree in just three years, saving you a year of tuition, books, fees and room and board.

Apply for scholarships. There are scholarships that will fit a variety of students, and if you submit applications for several, one or a few might come through. If you spend ten hours applying for scholarships and win $1,000, you’ve just been paid $100 per hour.

Work before and during school. Consider taking some time before you attend school to work and save some money for college expenses. Keep a part time job while in school to reduce the need for loans.

Managing Your Debt

There are a few things that you can do to keep your student loan debt from spiraling out of control.

Don’t ignore it. It won’t go away. Understand your balance, and the amount of interest and principal that makes up your required payment. Indiana University found that notifying students of their current balance and expected payments reduced the amount of additional loans taken by 11 percent.

Make at least the interest payment. Even if your required payment is less than the amount of interest on the loan each month. That will keep the loan from growing.

Use any windfalls, such as a tax refund or a bonus from work to pay down your debt. If you are already covering your monthly interest payments, every extra dollar you pay reduces the principal on the loan, getting you out of debt faster.

The income based student loan repayment plans do truly make life easier for struggling college graduates. While they can make the burden of payments easier to bear, they have a dark side. Understanding the terms of your repayment plan and actively managing your outstanding balance will keep your student loan debt from spiraling out of control.

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