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Keep the Wolve$ at Bay: Avoid These Student Loan Mistakes

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Down the Drain

Misunderstanding the key differences between student loans.

Not all loans are created equal. Most law students have several different kinds of student loans. The cost of borrowing and options for loan repayment and forgiveness depend upon which loans you have.

Today’s law students typically borrow some or all of the following kinds of student loans:

  • Direct Unsubsidized Loans: the lowest cost federal student loan available to students without regard for financial need. Because students are limited in the amount they may borrow in Direct Unsubsidized Loans, many law students also borrow Direct GradPLUS Loans.
  • Direct GradPLUS Loans: federal student loans for graduate or professional students without regard for financial need; GradPLUS loans accrue interest at a somewhat higher rate than Direct Unsubsidized Loans.
  • Federal Perkins Loans: school-based federal student loans for students with exceptional financial need. Perkins loans are at a fixed interest rate of five percent.
  • Private Bar Study Loans: commercial loan for law students, typically more expensive and less flexible than federal student loans.

Some law students will also have borrowed these types of loans:

  • Direct Subsidized Loans: federal loans made to eligible undergraduate students who demonstrate financial need. The government pays the interest that accrues on subsidized loans during certain periods of deferment, for example while students are in school.
  • Direct Consolidation Loans: a federal student loan that refinanced original federal student loans.
  • Direct PLUS Loans for Parents: loans made to parents of dependent undergraduate students to help pay for undergraduate education expenses not covered by other financial aid.
  • Older federal student loans from the Federal Family Education Loan (FFEL) program: Before July 2010, many students borrowed federal loans from banks and private lenders. FFEL loans are not eligible for all repayment programs or forgiveness options, so borrowers with these loans should consider the pros and cons of consolidation.
  • Private student loans: Because students are limited in the amount they may borrow through the federal loan programs, undergraduate students sometimes borrow private loans that are generally more costly than federal loans and typically require a co-signor.
    https://www.nslds.ed.gov/nslds/nslds_SA/

Confusing student loan interest rates

Your interest rate contributes to the overall cost of your loans over time. The rules about federal student loan interest rates have changed a lot over the years and you are likely to have many different interest rates. Here are the basics every student loan borrower should consider:

Before 2006, federal loans had variable interest rates. Since 2006, new federal loans are at fixedinterest rates set by Congress. Beginning July 1, 2013, rates are tied to the market:

  • Rates for unsubsidized loans to graduate students are: 10-year Treasury rate plus 3.60 percentage points (presently 5.41 percent), capped at 9.50 percent
  • Rates for GradPLUS and Parent PLUS loans are: 10-year Treasury rate plus 4.60 percentage points, (presently 6.41 percent) capped at 10.50 percent
  • Under current rules, your Direct Unsubsidized Loans and Direct GradPLUS loans will be issued based on the 10-year Treasury rate as measured on June 30 each year. This means that members of the law school graduating class of 2016 are likely to have different interest rates for each year’s loans.
  • Federal consolidation loans have fixed interest rates based on the weighted average of the underlying loans.
  • Private student loan interest rates are based on the lender’s evaluation of the borrower’s credit worthiness. They are usually higher than federal student loan interest rates.

Clarify your own interest rates by checking with your school’s financial aid office.

Underestimating the amount you will owe upon graduation

Interest on most student loans begins to accrue when the loan is disbursed. The amount of interest that adds up on your loan in a given month is determined by a so-called “simple” daily interest formula. This formula consists of multiplying your loan balance by the number of days since the last payment times an interest rate factor. The interest rate factor is calculated by dividing your loan’s interest rate by the number of days in the year.

Don’t be surprised when your loan balance upon graduation includes interest that has been adding up while you were in school.

Neglecting to update your contact information with your loan servicer

The US Department of Education uses several loan servicers to handle the billing and administration of federal student loans. Loan servicers send lots of important information to borrowers during the period following graduation including information about when your payments begin and how to select a repayment plan. If you miss your servicer’s communications, you may be enrolled in a repayment plan you don’t like or be late on payments. That can be expensive.

Steer clear of problems by updating your lenders and loan servicers with any new phone numbers, e-mail addresses, and mailing addresses. To find contact information for the loan servicer, check your record in the NSLDS.

Disregarding the pros and cons of consolidation

Because only Direct Loans are eligible for the Pay As You Earn (PAYE) Repayment plan and Public Service Loan Forgiveness, some grads will need to consolidate to benefit from these programs. But if all your federal loans are already Direct Loans, consolidation isn’t necessary.

You might want or need to consolidate:

  • If you have pre-2006 variable interest rate federal loans.
  • If you have pre-2010 FFEL loans and you qualify for the PAYE Repayment plan.
  • If you have pre-2010 FFEL loans and you want to earn Public Service Loan Forgiveness.

Be careful deciding whether to consolidate Perkins loans, because they have their own cancellation provisions that would be lost upon consolidation.

Beware of consolidating federal loans into a private consolidation loan—you would lose rights and protections like deferment, forbearance, cancellation, income-driven repayment, and Public Service Loan Forgiveness. Unfortunately, you cannot consolidate private student loans into a Direct Consolidation loan. http://loanconsolidation.ed.gov/

Misinterpreting the value of forbearance

Federal student loans allow for temporary postponements of payment called forbearance. If your budget it tight, you might be tempted to put your loans into forbearance. But forbearance gets expensive because interest continues to accrue and is added to the principal of the loan at the conclusion of the forbearance. This capitalization of interest means you will be charged interest on interest. Before deciding on forbearance, consider whether enrolling in an income-driven repayment plan makes more sense. Payments can be very low, even $0—and income-driven plans allow for interest subsidies for some loans and the possibility of forgiveness over time.

Overlooking repayment plan options

Choosing a repayment plan can be confusing, so take some time to fully understand the trade-offs between the different options. The Department of Education provides information and calculators regarding the various repayment options online at http://studentaid.ed.gov/repay-loans.

These are the highlights:

Standard Repayment

Standard repayment (for a loan that isn’t consolidated) means that you’ll pay equal monthly payments over a ten-year period. Monthly payments will be high, but because you’ll pay off your loan quickly, you will pay less interest. If you need low monthly payments, consider the income-driven repayment options.

Income-Driven Repayment Options

If your debt is relatively high as compared to your income, the income-driven repayment plans provide significant advantages. Monthly payments are established as a percentage of income so that when you don’t earn a lot, your payments are low. But the income-driven options have the disadvantage of requiring annual income verification and other paperwork, and because monthly payments are low, interest charges will be correspondingly high.

You’ll need to determine which income-driven options are available to you, and evaluate which of the available options provides the most benefits.

Under PAYE, annual payments are capped at ten percent of “discretionary income” and any remaining loan balance is forgiven after 20 years of qualifying payments. Also, payments made under PAYE can count toward Public Service Loan Forgiveness (more on that below). But PAYE is only available for “new borrowers” (those who (1) did not owe any balance on a federal student loan on October 1, 2007, and (2) received a federal student loan on or after October 1, 2011).

Under Income-Based Repayment (IBR), annual payments are capped at 15 percent of “discretionary income” and any remaining loan balance is forgiven after 25 years of qualifying payments. IBR payments can also count toward Public Service Loan Forgiveness. IBR is available for those of us who got our first student loan before October 1, 2007.

Missing administrative deadlines

To qualify to choose an income-driven repayment plan, you must provide documentation of income and certify family size. You must also update and recertify both income and family size annually, whether or not the information has changed. You will be notified between 60 and 90 days in advance of the date by which you must submit annual documentation.

The consequences for failing to do so are severe: If you do not provide the required annual documentation information by the deadline, your loan servicer will change your repayment plan to “standard” and capitalize unpaid by accrued interest. That’s expensive.

Avoid a startling bill and higher costs over time by reading and responding promptly to everything you receive from your loan servicer.

Forgetting to develop and periodically reassess your loan repayment strategy

Evaluate your consolidation, repayment, and forgiveness options in time to make a plan before your grace period ends and payments are due (typically six-months following graduation). And don’t forget to reevaluate your decisions when your circumstances change. Federal student loan borrowers have lots of options and your best strategy depends upon factors including your income, your family structure, and your financial goals. Stay on track by reevaluating your decisions periodically and every time your circumstances change—for example, if you get a raise, change jobs, get married, or have kids.

Failing to weigh the student loan implications of tax decisions and vice versa

It’s easy to get confused about how student loans and taxes are interrelated. Here’s what you need to know:

The income-driven repayment plans are driven by your adjusted gross income (AGI) as reported on your federal tax return. A married person who wants a monthly student loan payment calculated solely on the basis of his or her own income must file a separate federal income tax return. If a married couple files a joint federal tax return, a total payment amount for the couple will be calculated taking into account both spouses’ debt and both spouses’ income. A proportion of the total payment will be assigned to each spouse based on their share of the couple’s total student loan debt.

If a student loan borrower still has loan debt after 20 or 25 years of payments under an income-driven repayment option (depending on the plan), the remaining principal and interest is discharged. This discharge is taxable as income in the year in which it is received. But note that because it includes a service requirement, Public Service Loan Forgiveness is not taxable as income.

Consider getting some professional tax advice if your situation is complicated and make well-reasoned decisions by taking these steps:

  1. File a federal tax return while in law school even if you are not required to do so. This will help you document your income if asked by your loan servicer.
  2. If you are married, consciously determine whether to file a joint or separate tax return with your spouse based on the tax and student loan consequences.
  3. Anticipate, prepare, and save for any tax bill that you may owe if you receive debt cancellation.