February 16, 2021 Articles

Student Loan Repayment Strategies

Should you pursue loan forgiveness or refinance?

By Terry Andersen
There is a simple metric to help determine the most cost-effective option for you.

There is a simple metric to help determine the most cost-effective option for you.

Pexels | Alexander Mils

Correctly determining whether you should pursue loan forgiveness via an income-driven plan or refinance student loans to a lower interest rate is one of the most important financial decisions that you will make as an early career attorney. Thankfully, there is a simple metric to help determine the most cost-effective option for you.

Understanding Your Debt-to-Income Ratio

Your debt-to-income ratio is a simple yet effective metric to guide your student loan strategy decisions.

Below is the formula to calculate your personal debt-to-income ratio:

Debt-to-income ratio = Total student loan balance ÷ Total income before taxes

If your personal number is higher than 1.5, it is likely that pursuing loan forgiveness via an income-driven plan is your best option. Conversely, if your number is lower than 1.5, refinancing to a lower interest rate may produce tremendous savings.

Income-Driven Plans

The implication of a debt-to-income ratio over 1.5 is that your student loan balance is high enough relative to your income that pursing loan forgiveness is the most cost-effective option. In other words, it is unlikely that your income-driven payments would be high enough to pay down both principal and interest, producing a higher forgiven loan balance. Then, if you work in the private sector, you will owe taxes on the forgiven balance. However, keep in mind that the taxes are just a fraction of the overall loan balance.

This will sound counterintuitive, but the most cost-effective way to pay off loans using any income-driven plan is to make the lowest monthly payments possible. To reiterate, a higher loan balance will be forgiven, and you will simply owe a fraction of the loan amount (i.e., taxes due based on the forgiven balance).

Ask yourself this question: Would you rather pay a dollar today or 40 cents in the future? I hope you chose the latter, which represents paying taxes on a forgiven principal loan balance rather than paying the balance off dollar-for-dollar today.

Selecting Your Income-Driven Plan

For most attorneys, either the PAYE or REPAYE program will be the best option. PAYE is a pure forgiveness play. REPAYE is good for attorneys who would rather have a smaller tax liability in 25 years or for those who are planning to refinance eventually.

Private Refinancing

The implication of a debt-to-income ratio lower than 1.5 is that your income is high enough relative to your loan balance to produce income-driven payments high enough to pay down the overall student loan balance.

Remember, the objective of an income-driven plan is to have the highest loan balance possible forgiven. In other words, if the end result is paying down the loan balance, it is most cost-effective to refinance to a lower rate given the material interest savings. For example, paying an average interest rate of 6.8 percent on student loans will require $566 per month for every $100,000 borrowed just to cover the interest alone. Compound interest is a wonderful thing; compound interest in reverse is quite expensive.

Consolidation and Refinancing: Not the Same Thing!

Many attorneys mix up the terms consolidation and refinancing.

Consolidation is combining all of your loans into one federal loan. Unfortunately, the government averages the interest rates of all your loans and then rounds them up to the nearest 0.125 percent.

Refinancing occurs when a private bank or lender repays your federal loans and issues a new loan to you, typically at a much lower interest rate.

Refinance. Do not consolidate.

You Do Not Need to Refinance All of Your Loans

It is understandable to have pause about refinancing everything at the same time.

Perhaps you have an attractive fixed-interest rate on an undergraduate loan. There’s no need to include it in the package of loans that get refinanced.

Maybe you want to dip your toe into the water but keep some of your loans in the federal program. There is no requirement to refinance student loans in bulk.

Refinance the portion that feels comfortable and keep moving.

You Can Refinance Again Later

If you are just starting your career, you might not get the best rate due to your credit score and debt-to-income ratio. Or perhaps you have paid off half your loans and are now convinced that a variable rate makes sense for the rest of the payoff. There is nothing stopping you from refinancing your loans again.

Closing Thoughts

Ultimately, the debt-to-income ratio is a good rule of thumb and is not a hard-and-fast rule. There are unique situations, such as married couples with student loan debt, that require more nuanced analysis to make a conclusion about an appropriate payoff strategy.

Nevertheless, many attorneys feel lost when selecting an effective strategy, and the debt-to-income ratio is a wonderful compass.

Terry Andersen is a certified financial planner and founder of Tactical Wealth Partners, LLC, in Dallas, Texas.

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