Dealing with crippling student debt is (thankfully) something I’ve never had to experience myself, since in Canada our universities aren’t nearly as expensive and we did a co-op program that allowed us to work while we were studying to pay for our education. But student debt is something that many of our readers have to deal with, especially our American readers who regularly write into us with a ball and chain worth over $100k hanging on their necks. So I thought I’d take today’s article to address those people.
I first met Travis Hornsby at Fincon last year, and was impressed by how much he seemed to know about navigating the labyrinth student loan in the US. He runs a website called StudentLoanPlanner.com where he helps people navigate their own student debt situations, and he was gracious enough to talk to us about this problem so many people have.
Travis, thanks for doing this. First of all, what the Hell is going on with the US educational system? Why is student debt in the US so damned high?
The US has always made citizens carry most postsecondary educational costs. Of course, you also get to keep more of the returns in the form of lower taxes.
That isn’t the main contributor in the massive explosion of debt in the past decade though. In 2006, the Grad Plus program passed. Limits on borrowing disappeared. Since the Federal Government is the lender, no underwriting criteria are used to determine if the loan should be made.
At the same time, students could now pay based on their incomes and not the total debt borrowed.
University administrators are really smart people. They figured these new rules out and started raising prices even faster. With no borrowing limits, students just had to agree to sign their names. All of a sudden, there’s $1.5 trillion of student debt.
At Fincon, you told me you ran a site called StudentLoanPlanner.com? What are you hoping to do with it?
I want to stop people from tossing piles of cash in a furnace and setting it on fire. Most Americans with student loans are wasting thousands of dollars with a sub-optimal repayment strategy. The complexity of the student loan world invites mistakes.
I want borrowers to use the money for better things like getting to financial independence more quickly. So far, we’ve been able to identify about $44 million in projected savings for about 730 clients we’ve worked with 1 on 1.
I don’t track how much money our readers have saved, but I bet it’s a couple hundred million. We give away our best calculator away for free intentionally.
I want to get that savings number to $1 billion, then I think I’ll be pretty happy.
Yeah, *just* $1 billion. No problem.
OK enough beating around the bush. Let’s get down to brass tacks. When it comes to student loans, there are basically 3 different weapons you can use to take a whack at it: Refinancing, Payment Reductions, and Loan Forgiveness. Let’s talk about the first one. When does it make sense to refinance a federal government loan with a private lender?
Refinancing can make a ton of sense for folks at for profit employers who owe a reasonable amount compared to their income.
Look at how much you owe and divide it by your income. If you’re married include your spouse in that calculation. If that number is below 1.5, why keep your loans on the federal system at 5% to 8% interest when you could move it to a private lender that’ll charge you less.
If your “debt to income ratio” is more than 1.5, you need to think twice before refinancing student loans. Also, avoid refinancing if you work at a not for profit employer or might in the future.
These are rules of thumb, but you just want to make sure the benefits you get from a lower interest rate are better than the opportunity for loan forgiveness you give up.
Are there any downsides to refinancing? Why do you only advise people do it if their loan-to-income ratio is 1.5x?
There are a bunch of downsides to refinancing if you ever need the protections that federal student loans offer (or if you just owe a bunch of debt relative to income).
When you refinance, you lose income based repayment, forbearance, and loan forgiveness. That’s a lot to lose out on for a 1% to 2% lower interest rate.
Refinancing can be an outstanding way to get out of debt sooner. That said, it’s oversold in my opinion because there’s a lot of money behind ad campaigns with these well funded startups. Doesn’t help that most personal finance blogs get referral bonuses when people refinance but $0 bonus when they stay on a government repayment plan.
I don’t want to say that refinancing doesn’t help people. It can help tremendously. You just need to be smart in using it. That means 1.5 debt to income ratio at a private sector employer. Couldn’t hurt to have a solid emergency fund too.
Can you use 0-interest-rate balance transfer cards to do this?
You could, but the best 5-year variable rates right now are about 2.5%. When you do balance transfers, you usually get hit with a 3% transfer charge. That’s pretty close to the same result.
Pretend you lose your job and can’t move the debt to a new 0% card. Now that intro teaser rate resets to double digits.
Someone who owes less than $50,000 who doesn’t really care about getting a mortgage or a car loan might try this approach. It’s just like playing financial roulette with a loaded gun, so I don’t think I’d ever recommend that.
OK let’s talk about the second weapon. How do you reduce your monthly payments if you don’t make enough?
If you have federal loans, it’s easy. Just call up your loan servicer (the people who send you statements in the mail) and tell them you need to make an update to your income.
If minimizing the payment is the goal, I usually tell people ask for either Pay As You Earn (PAYE) or Revised Pay As You Earn (REPAYE) depending on what you’re eligible for. Your payment can literally be $0 a month.
Does it make sense to do this? If your new lower payment is less than the interest rate, won’t the loan just grow into infinity?
The interest doesn’t compound. Rather it grows at a simple rate. That does a lot to limit the balance in the most extreme circumstances where someone borrowed $300,000 but only earns $50,000 a year.
Maybe you’re just broke temporarily, so you game the system to get interest rate subsidies. If your goal is forgiveness, then eventually you’ll hit the 20-25 years of payments and be done.
OK that dovetails nicely into the third weapon. How does loan forgiveness work?
There are two systems depending if you work for a not for profit or for profit employer. The public servant one forgives all your debt tax free after 10 years of income based payments.
“Private sector forgiveness” requires 20 to 25 years of income based payments. At the end of that, the forgiven balance goes on your tax return as income. You’d owe as much as 40% of a very large number.
Who knows what politicians will do when this “tax bomb” they created starts coming home to roost. I just make sure people know that they’re going to owe a lot, and they need to prepare for it by saving a few hundred a month in index funds.
If you earn a lot of money relative to your debt, you’ll just pay it all back and get almost nothing forgiven while paying a lot in unnecessary interest. That’s the reason for that 1.5 debt to income rule for when you’d refinance or go for forgiveness.
OK yeah, you touched on a very strange aspect of the American student loan system. When students have their loans forgiven (and they aren’t eligible for the Public Service Loan Forgiveness Program), it gets added as taxable income which turns it into an IRS debt. Why is it done this way when other countries just forgive the loan outright?
Because when laws are made in America, they start with the goal of making it as incomprehensible and ridiculous as possible. Gold star if you kill a small forest while printing out the bill.
One point is that the taxable income event only happens for borrowers working in the private sector. If you’re in the government, academic, or not for profit world, you’re probably ok.
I think the real reason they did it this way is because it sounded good at the time and nobody properly thought through it. By the time the IRS issued their interpretation, Congress had already moved on to the next topic.
Expect future reforms to the system to address this. Eventually the IRS will send out a bunch of bills that can’t be paid, and they’ll be forced to address it.
For a new or current student thinking about taking on student debt, how much do you think is reasonable?
If you have wanted to be a dentist, doctor, lawyer, (fill in the blank) since you were 2, then I’m cool with borrowing less than double your expected first year income with the expectation that you’re gonna live really frugally for the first 5 years of your career to pay all the debt back in full.
Lots of professionals borrow more than that, and they’re on track to work til 65 or later. So just realize if you go to grad school and borrow a ton of money, the earliest you’ll be retiring is in a couple decades.
For people who just go to undergrad, the high cost private schools don’t seem to be worth it. If you’re going to an Ivy League they’re probably helping you out with tuition if you can’t already afford it.
But if you’re gonna go to a top 30 school and take on 50k in debt instead of a top 100 school that’s public (and leave with no debt) then I just don’t see the ROI in that decision.
The Republicans are trying to make changes to the federal student loan system. What are they, and will they make the situation better or worse?
They want to cap the total principal and interest paid and create a single income based payment program. The borrowing caps for grad school would be way lower than they are today. The bill would also get rid of the tax bomb problem while eliminating loan forgiveness.
If you’re a high cost private university (think Georgetown, NYU, USC, etc), this bill should terrify you. In fact, half of your tuition revenue might go up in smoke.
On the margins, grad school enrollment would have to fall if this thing passed. I think tuition would also drop at many of the most expensive programs without access to unlimited federal loans. That might be bad or good depending on your views.
Any other tips that you’d like to talk about that we haven’t already?
If you want to pay your debt off quickly, drive a clunker and live like a broke minimum wage worker and get rid of it really fast as long as the math supports payoff.
If you owe more than you could ever hope to pay back (double your income or more), you need to take a strategic approach and optimize the government programs for your benefit.
Pay back debt as aggressively as possible like your hair is on fire, or pay it back strategically and slow, taking max advantage of the government income driven options that promise forgiveness.
Most people make the mistake of taking an in between option and it’s really toxic for your finances.
Why do you care so much about helping people with their student debt problems?
I was really into the financial independence movement after spending three years in corporate America, but then life happened. I met my wife in Philly, and she revealed she had six figures of med school debt.
We spent a while trying to figure out the best way to pay it back, and I remember getting so frustrated navigating everything.
I didn’t see anybody out there giving math based help to borrowers who owed more than $100,000 but not a lot of time to spend figuring it out.
What should our readers do who have read all this info and are still struggling with student debt?
If you’re the kind of person that likes reading investment blogs and managing their own investments at Vanguard, then the Student Loan Eraser course I created will tell you everything you need to know in about 3 hours.
If you’d rather have us figure it out for you, email me at [email protected] and tell me what you’re dealing with.
Awesome. Thanks Travis!
Are you struggling with student debt? Sound off in the comments!
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