“Dear Steve,
I have a question about my student loans. When I first graduated from graduate school, I was eligible for pay as you earn. This is because while I was in school, I had very little income, and I didn’t start working right away and so only had a partial year of income.
I signed up for the pay as you earn plan because it made a really big difference in my budget – My current payment is less than half what it would be under the standard repayment plan, and the payment will stay where it is until July 2016 (I just confirmed with my servicer).
My principal balance is just over $100k and the average interest rate is 7.1%, however because I am on Pay as you Earn, I am paying an effective average interest rate of 5.5%. (Although I believe some of this difference in interest is actually being added to the principal balance of my loans, effectively increasing the loan balance over time)
I got married and this year will file joint tax returns for the first time. My 2015 income plus my husband’s income will put us in the $250k+ income bracket. (We are very fortunate, I know) I know that this means when I submit my income documentation in early 2016, I would expect my loan payment to change back to the amount it would be under the standard repayment plan.
I can now afford a higher payment, but I have kept the pay as you earn plan because of the decreased interest rate. I have excellent credit and thus am eligible to refinance with a private lender which could drop my rate to about 2% variable or 4% fixed.
I am trying to understand what benefits I am giving up if I were to refinance for this lower rate. For example, the forgiveness of unpaid balances after 20 years, or the “option value” of the pay as you earn – if in the future, I lose my job or take a lower paying job, my payment would go back down (I think). I also know that interest rates won’t stay as low as they are now forever, and I don’t want to lose the opportunity to lock in a low rate and be penny wise, pound foolish.
Thank you for your advice!
Carly”
Dear Carly,
You are correct, the unpaid interest is piling up on the back of your loan. This is why I recommend avoiding these payment plans if possible. See Why Income Based Student Loan Payments Can Be a Terrible Trap for a longer discussion about this.
The biggest risk seems to be consolidating with a private lender. Should you run into trouble in the future, there are no payment reduction programs like the federal government offers.
With your projected awesome income it is unlikely you will reach a 20-year forgiveness point and you will instead find your payment raised to the 10-year standard and you’ll repay your loan quicker with that payment. Getting rid of student loans as quickly as possible and/or starting to save for retirement with money you can spare above your 10-year payment, I think is the smartest thing to do at this point.
Ultimately, you will pay the lowest overall cost by maximizing payments and eliminating the balance quickly. A lower interest rate strung over a longer period of time can wind up being more costly.
Please post your responses and follow-up messages to me on this in the comments section below.
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