By Drew Hefflefinger, CFP®
Consolidation, income-driven repayment and private refinancing are three commonly confused topics in the student loan world. All can help customize repayment, however, all are very different. In repayment it is worthwhile to understand the options and see how each strategy can be applied to your personal situation.
Typically, a standard federal student loan is issued as a 10-year term paid in equal monthly payments… all very cookie cutter. But we are not cookie cutter; we are all different. Some landed in private practice, others are working in government or non-profit, you may have hung your own shingle, others are still trying to figure it all out. Whatever the situation, the typical 10-year term may not be best…
Consolidation is a term specific to federally issued loans by the US Department of Education. You are only able to consolidate your loans once and typically because you cannot swing the cookie cutter monthly payment. Consolidation allows the borrower to take the 10-year term and extend it up to 30 years. By extending the term of the loan monthly payments go down and the total interest paid rises. This has an immediate pro and long-term con. Lowering payments today can help tremendously with cash flow, however, it means paying the loan for a longer period of time and paying much more in interest. But we all grow, if you evolve into a higher paying role additional principal payments can be made and reduce total interest paid over the long run.
Income-driven repayment plans determine the monthly payment based on a formula taking into account income and family size. Depending on when you took out your first loan you can pay anywhere from 10 to 15 percent of discretionary income and in many cases lower your monthly payment. The consequence however is two-fold. Of most importance, the program’s term is 20 to 25 years max — this is a long time and significantly increases total interest paid. Second, if there is a balance at the end of the 20 to 25 years the balance is considered forgiven and the forgiven amount is 100% taxable. To compound matters, the projected balance could be higher than your balance today due to negative amortization, or “paying interest on interest”. At the moment this is how legislation stands, however, buzz has already started about making the forgiven balance tax-free. Nevertheless, if you have high debt and relatively low income this may be the only option to keep you current.
Private refinancing is on the other end of the spectrum and increases risk and potential return. Here you are approaching private lenders like a bank or lending institution with the goal of getting a lower interest rate. In the consolidation and income-driven strategies the weighted interest rate does not change, with private refinancing it is the goal. The big risk is losing all of the benefits associated with Federal Loans including the 270 day window for missed payments, deferment, forbearance, etc.. Losing these benefits could lead to disaster to the lawyer just starting out — but if you are at a strong firm, with stable income, and emergency savings this strategy is worth considering. In many cases you can save tens of thousands in total interest paid by just getting a lower interest rate! There is a reason why people refinance their homes when rates are low, why not your “condo-sized” loans?
So what should you do? First, have a clear understanding of your own financial situation before you make any decisions — these decisions are going to change your loans forever. Second, it is important to carefully consider all options before moving forward with a particular strategy — we always want to make smart and informed decisions. Third, these are complex decisions and if you do not have the time, patience, or expertise seek someone who does, I am happy to help.
Drew Hefflefinger is a CERTIFIED FINANCIAL PLANNER™ at Private Client Wealth Advisors, LLC in Denver, Colorado. Drew specializes in working with young attorneys by helping them preserve and grow their wealth while achieving their life goals. Drew can be contacted at firstname.lastname@example.org.