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Common Mistakes When Repaying Student Loan Debt

With the cost of higher education increasing, student loan debt for health professionals has more than tripled over the last 15 years.  For example, the national average student loan debt for medical school graduates surpassed $150,000 in 2009*.  The combination of high debt levels, relatively low starting salaries, and very busy schedules often leads to costly mistakes when recent graduates enter repayment on their student loans.

Below, we have outlined six common mistakes that may result in increased costs and missed opportunities to save thousands in interest on your student loan debt.  Understanding your options and taking a strategic approach to managing your debt can have a significant positive impact on your financial net worth.

Treating all debt equally

Student loan borrowers often treat all of their student loans the same during repayment.  Many borrowers set up a standard payment plan and use automatic debit, essentially putting repayment on cruise control until their debt is retired. Some borrowers may choose to pay extra, but unless specified, the additional contribution is allocated across all of their loans equally.  This strategy is flawed because it does not account for the wide variability in interest rates that exist across a typical student loan portfolio.

The alternative to the above approach is to implement a targeted repayment plan that lowers the interest cost of a borrower’s debt portfolio by retiring the higher interest rate loans more quickly.  This is accomplished by directing a majority of the monthly loan payment toward the higher rate debt. Federal loan repayment options such as forbearance, extended payment plans, and deferment may be applied to lower interest rate loans in order to free up additional funds to target the higher rate debt. Although this strategy is rarely practiced, it should be considered as a repayment option, as the interest savings can be substantial.

Overusing forbearance

Graduates who carry high levels of debt and experience tight liquidity during their residency, internship, job search or first year of employment may rely on forbearance to postpone their student loan payments.  Many borrowers believe forbearance is the only viable option to delay payments once their grace period ends. However, borrowers must recognize that while forbearance does suspend payments, it can be a costly option because loans continue to accrue interest. For example, a graduate with $165,000 in debt at today’s rates accrues close to $1,000 a month in interest during the forbearance period, all of which will be capitalized or added to the total loan balance to be repaid.**

Fortunately, other options are available.  For instance, deferment also suspends payments, but the government will pay the interest on the subsidized portion of the loans. Qualifying for certain types of deferment has become more difficult but the government recently added a new payment relief program called Income-Based Repayment (IBR) that provides borrowers with lower monthly payments based on their income. IBR also includes a subsidy for up to three years for qualified borrowers.

The key is to understand that forbearance can sometimes be an effective tool; however, you should always consider less costly alternatives.

Failing to learn about new repayment options

Each year seems to bring changes to programs concerning federal student loans. Unfortunately, borrowers are often unaware of how these changes may impact their financial situation. Currently, there is significant confusion and misunderstanding surrounding two federal loan relief programs that have recently received attention: IBR and Public Service Loan Forgiveness (PSLF).  Many borrowers have not been informed of the eligibility requirements and benefits of these programs and therefore, some borrowers who qualify are not actively taking advantage of these programs. Understanding the details of these and other programs is important as they can provide you significant cost savings if implemented properly.

Below is a summary of the aforementioned federal programs:

IBR: Limits monthly loan payments to 15% of a borrower’s discretionary income, and for up to three years after repayment begins, the government will pay the outstanding subsidized interest. Additionally, after 25 years of qualifying payments, any outstanding balance is forgiven. Please note that beginning July 2014, the government will limit payments to 10% of discretionary income and will forgive all outstanding debt after 20 years for new borrowers.

PSLF: Provides tax-free loan forgiveness to federal loan borrowers who make 120 qualifying payments. Residents and physicians employed by non-profit organizations such as hospitals or universities may qualify for this program. Unlike other forgiveness programs, there are no limitations regarding geography, type of medicine practiced, or types of patients treated.

Filing tax returns without optimizing for student loan debt

How and when a recent graduate files their taxes can have a direct impact on their student loan related savings. Since IBR monthly payments are based on a borrower’s annual gross income (AGI), it is critical to enter IBR at the appropriate time and understand how tax returns or alternative income documentation will be used to determine the monthly IBR payment amount and affect the subsidy.

Married borrowers must also consider the benefits of choosing “married filing jointly” versus “married filing separately” status. This decision is dependent upon several factors including each partner’s income and federal educational debt levels. In addition, certain graduates below an income threshold are currently able to recognize tax savings on student loan interest paid up to $2,500 a year for at least the first 5 years of repayment.

To ensure you receive the greatest savings, you should discuss your options with a tax professional who understands how your tax filing status can impact your student loan repayment.

Relying solely on lenders’ advice

As a recent graduate, it is common to rely on a lender’s advice and support in determining how to best manage student loan debt. Unfortunately, recent industry changes have forced lenders to scale back on programs and redirect resources that previously supported borrowers. Lender resources are often not directly aligned with borrowers’ best interests. While lenders and loan servicers are not reluctant to assist borrowers, their priorities are often to optimize their processes, increase efficiencies, and maintain the status quo in order to minimize their cost structures and prevent loan defaults.  This can result in a conflict of interest with borrowers whose main priority is to lower the cost of their debt.

An example of this conflict of interest is a lender who encourages Residency Forbearance over other less costly options for the borrower. Also, many lenders may not advise borrowers to explore Public Service Loan Forgiveness because this program is not applicable to the Federal Family Education Loan Program (FFELP) loans they service and could result in lost business.

When you are evaluating your situation, it is advisable to do some research on your own or to seek advice from reliable alternative sources to ensure you fully understand your options.

Managing debt without the assistance of experienced support

With the proper research and significant due diligence, a recent graduate may be able to manage their student loan debt independently. However, most health professional graduates neither have the time nor the resources to manage it appropriately at such a critical point in their career. Student loans and related federal programs are nuanced and it can be very difficult to take full advantage of them without an in-depth understanding of the details. For instance, due to the confusion regarding these new federal programs, many are led to believe IBR would require monthly payments in the $400 range. However, if structured properly, IBR payments can be reduced to below $100, as appropriate, allowing most health professionals to benefit from the program. Also, the timing of when to implement the appropriate strategy can affect a borrower’s ability to obtain the lowest payment and maximum economic benefit.  Working with a trained financial professional, such as a tax accountant or financial planner familiar with student loans, is highly encouraged in order to ensure you make the appropriate financial decisions regarding student loan repayment, tax filing and general financial planning.

* Based on data collected by AAMC, AMA

**Assumes $165,000 in combined Direct Subsidized and Unsubsidized at 6.8%