Each of us is faced with competing financial priorities throughout life. Those of us who financed our education with student loans have one additional factor to consider as we plan our futures.
As of June 2020, the total outstanding student loan debt in the United States stood at $1.67 trillion. According to the National Center for Education Statistics, the average cumulative education debt after law school was $148,800 for the class of 2015–2016. You are not alone if you feel overwhelmed!
Many young lawyers are having trouble making ends meet and are unable to satisfy student loan obligations—for now, anyway. Their focus is on identifying affordable repayment options. Others have discretionary income available after satisfying all monthly obligations (including student loan payments). The issue that they face is how to most prudently allocate excess resources.
This article is aimed at both groups and is intended to provide information to consider when creating a sound financial plan moving forward. Assessing current reality in detail is the first step no matter your circumstance. A sound starting point is to list all your debts, including student loans, car loans, credit cards, and any other type of personal debt. For each, list the loan balance, interest rate, and minimum monthly payment. With respect to student loans, be sure to clarify whether you have a private loan or federal student loan. Protections associated with federal loan programs may not be available for private loans, as pointed out below.
Drowning in Student Loan Debt?
Let’s start by outlining a few options for those having difficulty making student loan payments.
Student loan consultant Jan Miller graciously agreed to share his perspective with readers of this article. He revealed that a significant number of attorneys have found themselves with upside-down debt-to-income ratios. For some, the student loan debt exceeds their annual income—sometimes by as much as two or three times.
Miller emphasizes the importance of analyzing the effects of different repayment options on lifetime costs and recommends a holistic strategy, taking into account not only “the numbers” but also life circumstances such as income growth potential, career trajectory, and family situation, considering both the short and long term.
Many attorneys making payments pursuant to the ten-year Standard Repayment Plan (10 to 30 years for consolidation loans) feel financially strapped. Fortunately, options are available that will not only provide immediate relief but also free up funds to pursue other financial goals.
COVID-19 emergency relief. By executive order, President Joe Biden put the following relief measures into place with respect to student loans held by the U.S. Education Department: Loan payments are suspended, collection efforts are stopped, and interest is waived. While this short-term solution, which is effective through September 30, 2021, provides breathing room, it is the long-term issue that needs to be addressed.
Consolidate or refinance. Those with multiple student loans may wish to explore whether applying for a Direct Consolidation Loan (https://tinyurl.com/yxd78bl8) would result in lower payments. Because the application process is free, why not give it a try if you have more than one outstanding student loan?
With private loans, it can make sense to refinance if a lower interest rate or more favorable terms are available. Consult with a private lender to determine your eligibility.
Income-driven repayment plans (IDR). These plans allow the borrower to reduce the monthly payment to an affordable amount. The payment obligation will be between 10 percent and 20 percent of discretionary income depending on which of the four plans is chosen: Revised Pay As You Earn (REPAYE), Pay As You Earn (PAYE), Income-Based Repayment (IBR), or Income-Contingent Repayment (ICR). Because the loan term is extended, the cumulative amount of interest paid will be more than under the standard repayment plan. However, that is a small price to pay for financial relief. Any remaining loan balance is forgiven if your loans aren’t fully repaid at the end of 20 or 25 years—again, the terms are dictated by the particular plan. Any amount forgiven may be includable in your taxable income.
Public Service Loan Forgiveness (PSLF). In order to qualify for loan forgiveness, the borrower must make 120 “qualifying” loan payments while working for a “qualified” employer. If you intend to satisfy the standard of the PSLF program, you are well advised to apply for an IDR plan. Otherwise, the loan will have been paid off in full at the end of ten years under the standard repayment plan at the same time you would perhaps qualify for forgiveness. Check out the Federal Student Aid website for detailed information (https://tinyurl.com/y4l7knoy). Notably, less than 2 percent of applications filed have been approved since 2017, when the first group of borrowers was permitted to file forgiveness applications.
Deferment, forbearance, or bankruptcy. Although this author is not generally in favor of these three remedies, sometimes they are the only viable alternatives. Each is briefly described in the following paragraphs.
Deferment or forbearance. These options may be available to those with federal student loans. Under either alternative, the borrower is permitted to temporarily postpone or reduce payments on student loans. With deferment, interest generally does not accrue, whereas interest continues to accrue if the loan is in forbearance. The Federal Student Aid website provides useful detail with respect to these programs (https://tinyurl.com/y488f67k). Those with private loans will need to check with their lenders to determine the availability of this temporary relief.
Miller cautions that making a sound decision about which direction to take involves more than using an online calculator because creative solutions may be available. Not only can the regulations be complex, but you never know when change is on the horizon. A misjudgment at this juncture can carry with it lifetime consequences. This author agrees that, in some circumstances, it is advisable to seek professional help making these important financial decisions.
Bankruptcy. In rare situations, filing for bankruptcy may be warranted. However, the borrower must satisfy the “undue hardship” standard (the “Brunner” test) in order for a discharge to be available under either Chapter 7 or 13. In January 2020, Chief U.S. Bankruptcy Judge Cecelia G. Morris “recalibrated” the Brunner test and granted a discharge of debt that exceeded $200,000. An appeal to this decision is pending before the U.S. District Court for the Southern District of New York. Stay tuned.
By the way, surveys show that a significant number of student loan borrowers live with anxiety and depression. Self-assessments are readily available that can help determine whether it would be useful to consult with a professional or take advantage of other well-being resources now accessible online. Check out www.legalburnout.com, the website of an attorney well-being resource co-founded by this author.
Wondering How to Allocate Excess Resources?
Attorneys who are easily able to make their monthly payments must analyze the most advantageous allocation of their “excess income.” First and foremost, I recommend creating an emergency fund and then paying off the principal of high-interest loans.
The next decision to make is whether to first pay off student loans or save for a down payment for a house or pay off other debt or save for retirement. There is no one right answer because each person has his or her own financial mission as a guiding light.
Federal student loans. While making minimum payments on federal student loans is obvious, in most cases there doesn’t need to be a big rush to pay off principal. They normally carry a low, fixed interest rate and also have flexible options as described in the previous section. Keep in mind that up to $2,500 in interest payments made on student loan debt may be tax-deductible, depending on the taxpayer’s modified adjusted gross income (MAGI). An individual with MAGI in excess of $80,000 is ineligible for the deduction.
Create an emergency fund. This author highly recommends prioritizing creation of an emergency fund. When a significant and unexpected expense arises (and it surely will), having a rainy-day fund available eases the sting and provides a feeling of security. Perhaps you will need to replace an appliance or pay for an expensive car repair. Having a safety cushion to rely on in the event of unemployment or a downturn in business is also wise. The rule of thumb is to maintain a minimum of three to six months of expenses in reserve. If you don’t yet have an emergency fund, start by setting a savings goal and opening up a separate, high-yield savings account that is readily accessible. Each month, allocate a comfortable portion of your discretionary income to be added to the account until the goal is met. It’s simple but not always easy.
Pay off high-interest debts. Your next priority should be to allocate funds to pay down the principal of the debt with the highest interest rate—typically credit cards, personal loans, or even private student loans. Once the first debt is satisfied, begin paying toward the principal of the one with the next highest rate.
If the interest rate of your car loan is high, then certainly begin satisfying that obligation. Otherwise, it is not a bad decision to just keep making the monthly payments while simultaneously saving for retirement, saving for the down payment for a home, and even socking a few dollars away for your child’s college education. It’s up to you to decide where your priorities lie among these options. Hopefully, you have room in your budget to allocate funds to each category.
As an aside, another factor to take into account when determining which loan to pay first is whether someone has graciously co-signed for you. It would be a nice gesture to pay off that loan first because the co-signer’s future borrowing power is reduced until the co-signed loan is satisfied.
Consider the following viewpoints as you are determining how best to integrate repayment of student loans with these other aspects of your financial future.
Contribute the Maximum Amount to Qualified Plans
Young attorneys who start contributing to a retirement plan today will have a significantly more secure and comfortable retirement than those who wait until age 60 to begin this process. If your employer has established a 401(k) plan and matches employee contributions, contribute enough to collect your full employer match. Note that elective salary contributions are limited to $19,500 per year in 2020, which allows you to add more to your nest egg if your budget permits.
Solo practitioners and partners in small firms wishing to maximize involvement in tax-deferred plans are encouraged to explore the features of the Simplified Employee Pension Plan (SEP) IRA and the Savings Incentive Match Plan for Employees (SIMPLE) IRA. At the very least, establish an IRA. For 2020, the maximum annual IRA contribution is $6,000, or $7,000 once you reach age 50. Squeezing even this amount out of your budget will yield huge long-term results, as illustrated by the following example:
Illustration of the power of tax-deferred growth. Becky is 29 years old and is able to satisfy her monthly obligations (including student loan payments). She manages to squeeze $500 out of her budget each month, which she contributes to a traditional IRA. When she reaches age 50, she begins contributing $7,000 on an annual basis. Presuming a 7 percent rate of return and an effective tax rate of 25 percent, Becky will have accumulated a retirement nest egg of $982,912 when she reaches age 65, in addition to other investments or properties in her portfolio.
Save for the Down Payment for a Home
Owning your own home carries with it many benefits, which is why we are willing to assume the accompanying responsibilities. Because real estate generally appreciates in value, it can prove to be a sound investment, allowing you to build equity. At the same time, you have the emotional satisfaction of homeownership and the monthly payments may be less expensive than a rental, depending on the circumstance.
A down payment of at least 20 percent of the purchase price is advisable for conventional loans because this allows you to avoid the expense of private mortgage insurance (PMI). According to Genworth Mortgage Insurance, the average cost of private PMI ranges from 0.55 to 2.25 percent of the original loan amount annually. If you are drawn to a Federal Housing Administration (FHA) loan because it requires only a 3.5 percent down payment, be sure to consider the overall cost of the loan before signing on the dotted line.
Once the decision is made as to the amount that you need to save, commit to placing the amount you will allocate each month into a separate savings account. Arranging for an automatic direct deposit will help you avoid the temptation to spend instead of save.
Save for the College Education for a Child
There is no time like the present to start saving for your children’s future education. Two tax-qualified options to consider are 529 Plans and the Coverdell Education Savings Account. Check out Internal Revenue Service Publication 970 (https://tinyurl.com/y4v8z3gk) if this topic is relevant to your current situation.
Now, Take Charge!
Long ago, I was taught that “what gets measured gets managed.” From my vantage point, this means thoroughly researching all options, having a written financial plan, reviewing progress on a monthly basis, and tweaking the plan as circumstances change. Why wait? Start today.