We get dozens of requests each week for loan advice. We obtained permission from this reader to use their actual details in a walk-through. We hope that by providing this analysis publicly, others might better understand their options and learn how to use our Tools and Calculators to figure out their own situation.
Charlie and the Loan Interest Factory
Charlie is a surgery resident in California, PGY-4, married with a child and a stay at home husband Ron in a very high cost of living area.
She has nine student loans and has not yet made any payments (she is in forbearance). The total interest plus principal on these loans is currently about $411,000, with an overall (weighted) interest rate of 7%. Interest is accumulating at $28,770 per year.
In addition, Ron has loans of $3500, and is making payments of $250 per month.
They have not been making loan payments on Charlie’s loans due to the realities of living on a salary of $75,000.
Charlie's residency is a qualifying employer for Public Service Loan Forgiveness (PSLF) and she has three more years of training. She is unsure whether her future jobs will also be for qualifying employers. Ron is trained as a social worker, and may return to work in 2-5 years, hopefully half-time with an annual income of perhaps $30,000.
Charlie and Ron wonder whether they should be doing something different with their loans.
The Short Answer
Charlie should immediately start making payments under the REPAYE plan. It will cost them $3600 per year with their current income, but they will receive annual subsidies of more than $12,000 PER YEAR throughout Charlie’s training. In the future, based on reasonable assumptions, Charlie will have $324,000 in loans forgiven if she remains in a PSLF-eligible job. If not, the interest subsidies are hers to keep, and she can refinance later to a lower rate (hopefully). Refinancing now is not an option because they cannot afford the payments and it doesn’t matter, because refinancing is only a better option if they can get their rate below a fixed rate of 4%, which is likely not possible.
The Long Answer
Forbearing student loans is very costly compared to other alternatives. During forbearance interest accumulates and one pays “interest on the interest”. In contrast, when making federal student loan payments under an income-driven plan such as PAYE, REPAYE or IBR the interest is only charged on the principal while the interest accumulates “on the side” at zero percent. This has the net effect of decreasing your overall borrowing costs.
While we appreciate that supporting a family of 3 on a resident’s salary is not easy, Charlie is making a very expensive mistake that is unfortunately all too common. For those with low income and high loans, the REPAYE payment plan provides generous interest rate subsidies which are not dependent in any way on the PSLF. We suspect too few know and understand how these subsidies work.
To better understand these subsidies, we will go through the calculation for Charlie’s REPAYE subsidies here. First, we used our Weighted Average Interest Rate Calculator to calculate the combined loan balance and interest rate. We used their 2017 “adjusted gross income” (AGI; line 37 on their 1040), which was $67,116. Using our Simple Income Driven Payment Calculator we entered their loan balance, interest rate, income (e.g. AGI), and family size. For now, all we need to know is their payment under the REPAYE plan, which is $300 per month, or $3600 per year. You may also note two other numbers: The PAYE/IBR payment “cap” of $4772 and the income needed to reach this cap of $603,817. There will be more on this later. Here's what their calculator input/outputs look like:
Under the REPAYE (but not any other plan), one-half of any unpaid interest is subsidized with each payment. Charlie’s interest is currently almost $29,000/year ($411,000 times 7%). But REPAYE payments would only be $3600/year, all of which would go towards the interest. Thus, the annual interest which remains unpaid would be: $29,000 - $3600 = $25,400. Half of $25,400 is $12,700. Thus, by starting REPAYE payments of $3600, the federal government would kick in an additional $12,700 towards the loans! For many, this is the equivalent of a $25,000 raise (because loan payments are paid back with after-tax dollars). Alternateley, who wouldn't pay $3600 now to get 350% "cash-back"?!
What about PSLF?
Because Charlie is currently in a PSLF-eligible job, she shoud assume that she will receive PSLF. That is, if there is any chance one will remain in an eligible job, one should work towards PSLF. The reason is that the upsides of PSLF are huge (massive loan forgiveness), while the downsides are trivial. The worst case scenario in this case might occur if one assumes they’ll get PSLF but then at the last moment is not eligible. In that case, the only cost to you is the little bit of extra interest you paid during the years when you could have refinanced into a lower rate (if available) and made aggressive payments towards the loans. In most cases, this extra interest is more than offset by the fact that PSLF-eligible payments under an income-driven plan are usually a lot less than those required by refinancing. This savings can be (and SHOULD BE!) used to contribute to a deductible employer retirement account. This has the effect of lowering AGI and further reducing income-driven payment amounts, which also increases your forgiveness by 10% of your contributions. In addition, it’s possible that over time the return on your investments will exceed the extra interest paid on your loans.
Choosing a Repayment Plan
There are only three plans to consider for PSLF: PAYE, REPAYE, and IBR. Everyone is eligible for REPAYE. Not everyone is eligible for PAYE or IBR, so the first step is figuring out PAYE vs IBR eligibility. If PAYE-eligible, one would compare PAYE to REPAYE, because PAYE is always better than IBR. If not, compare IBR to REPAYE. Thus, there is always (at most) two options. Charlie happens to be eligible for PAYE, and thus we will do a PAYE vs REPAYE comparison. Coincidentally, we of course have made such a tool available. It's objectively the best on the web, and it’s FREE.
For PSLF, we’d like to choose the plan which minimizes payments for a given set of projected income assumptions. Charlie estimates an income of $350,000 after training, while Ron may return to work half-time as a social worker. We’ll enter a reasonable set of income assumptions for each of them for the next 10 years, as seen here:
The chart and graph below shows what their payments would be under: a 10-year payment plan; PAYE (if they file taxes separate); PAYE (if filing jointly); and REPAYE (joint income must be used). In addition, we can see their interest subsidies with REPAYE, and can calculate their “effective” interest rate after taking subsidies into account. Because PAYE and REPAYE payments are each 10% of their discretionary income, their payments are the same under each. That is, until Ron has income and if they choose to file separately. Even though filing separately would reduce their payments in the future, the reduction would be small, and they would pay more in extra taxes by filing separately than would be saved in loan payments. So in their case, filing separately is not something that needs to be considered (unless one day Ron has much more income than anticipated).
Note the blue dotted line above. This is what their “standard” 10-year payments would be. This is important, because this number is used to calculate the “cap” for PAYE and IBR. The cap is the maximum monthly loan payments, no matter what their income increases to. We had previously calculated this cap at $4,772 using our payment and cap calculator tool. The income needed to reach this cap was about $604,000. As you can see, their joint income will likely never reach this, and thus the cap will not come into play. But for many borrowers (especially those on IBR), the cap will limit PAYE/IBR payments and has the effect of making PAYE/IBR potentially much more attractive than REPAYE under the right conditions. Note that if they find their joint income will somehow exceed this cap, they have the option of doing a REPAYE to PAYE switch (prior to the increase in income) which would keep their payments under the cap with PAYE (but would otherwise be over the cap if they stay in REPAYE).
For PSLF, any amount not paid after 10 years is forgiven and thus the goal is to minimize payments during that time. Below is a graph which shows the cumulative costs under each option (same legend as above). Note that regardless of the chosen plan or filing joint/separate, the total costs after 10 years is approximately $250,000. This is substantially less than would be paid if one were to refinance, even to a lower interest rate.
So what’s the summary of all this data?
First and most important is that Charlie and Ron should do everything possible to come up with the $3600 per year needed to start payments under REPAYE. They are throwing away $12,000+ in free money, this year alone. In addition, they are delaying very valuable payments which would count towards PSLF. Ron has $250/month payments on his loan. If they cannot afford the $300/month to start REPAYE, Ron should consider suspending payments on his loans (if allowed) and using that money for REPAYE payments for Charlie. Otherwise, they should beg, borrow, or steal to come up with $300/month in some other way. Making REPAYE payments allows them to keep the subsidies regardless of future PSLF eligibility. If at any point Charlie finds herself ineligible for PSLF, she can simply choose to refinance (or not) at that time.
Thank you Charlie and Ron for allowing us to write publicly about your financial situation.
If you have any questions about this analysis or questions about using our tools and calculators, please ask them in the comments section below!