Last month in Part I, we detailed several options for students to pay for their college education, including both governmental loans as well as private lenders. Now that we explained how to get INTO debt, in Part II and III we explain how to GET OUT of it. If you have not done so, we suggest you read Part I first, since many of the terms/provisions of federal loans are outlined and are not rehashed in Part II and III.
One of the main issues revolving around student debt is that it is nearly impossible to get out of; it is one of the rare forms of debt that does not get washed away by bankruptcy. Missed payments also can damage credit scores, making it difficult to borrow to buy a home or a car. Lenders can garnish wages, and the federal government can also withhold cash from defaulted borrowers' federal income-tax refunds and Social Security benefits. This has led to a huge problem, as losses are mounting as more borrowers fall behind on payments. Ten percent of the 4.7 million federal student-loan borrowers who began paying back their loans from October 2010 to September 2011 had defaulted by Sept. 30, 2012, the Education Department says. That is the sixth consecutive year of rising defaults. So what exactly are the options in order to alleviate the burden of their mounting debt?
Federal Debt Consolidation
You may be able to consolidate your federal loans into one single loan with one single fixed interest rate and thus one single payment through the federal loan consolidation program. Logistically, this is a great benefit, as it simplifies your life – keeping track of several different loans, payment terms, etc. can be quite cumbersome. If you are already in the payback period on your federal loans, by simply consolidating, you are hitting the “reset” button on the standard loan term of 10 years – this will lower your current monthly payment and give you a bit more breathing room while not fully extending the loan term (as noted below). Your interest rate is simply a weighted average of all of your federal loans – thus, you are not really gaining financially from consolidating. In fact, since you are extending the amount of time for paying back your loans, you are actually paying more in interest over time. However, if you consolidate immediately after graduation, this additional interest will be minimized, and consolidation may make sense for the simplification that consolidation offers. The greater into the 10 year term you are, the less sense this makes.
You also have the ability to extend the loan payback terms from the standard 10 years to 12-30 years depending on the amount borrowed. However, it may not always be prudent, and in many cases, you will pay significantly more in interest over time. For some of you, this may be the best option, particularly if you cannot meet your living expenses and other debt. The government offers a repayment estimator which can be used to see your monthly payment along with the additional interest you will pay over the course of the life of your extended loan under the consolidation program. We recommend you utilize this tool in making the correct determination and do not use debt consolidation agencies, some of which were recently maligned right here in Chicago.
Debt consolidation offers other possible benefits. Consolidation loans renew your deferment and forbearance eligibility for both federal and private loans (as explained below). This can be useful in a few circumstances. If you are currently in default on your federal loans, the government does not allow you to defer/forbear. If you consolidate, you now have a brand new loan, and a brand new ability to qualify. Consolidation also offers a useful tool for medical school students, who do not get an in-school deferment during the internship and residency periods. They are, however, eligible for an economic hardship deferment for up to three years. If they need more than three years, consolidation is a useful tool for getting up to another three years of deferment.
There are a few other caveats to be aware of with federal consolidation. When a borrower consolidates during the grace period (the period after graduation before you must make your first payment), the borrower has to begin repayment immediately and loses the remainder of the grace period, including possible interest benefits on subsidized loans. You should also consider the implications of consolidating a Perkins Loan during the period of deferment, since you lose such deferment upon consolidating your loans, as well as the favorable loan forgiveness provisions of this particular loan.
If you have private loans, chances are you understand the steep costs of such agreements. Many of these loans carry interest rates higher (and in some cases significantly higher) than governmental loans. However, you may have a great opportunity to consolidate your private debt and in doing so stop the bleeding.
Similar to governmental loans, you may have the ability to consolidate your private debt, extend the term, and thus lower your monthly payment, at the expense of possibly more interest paid over the course of the consolidated loan. Again, this may make sense if you cannot meet your monthly expenses. You may also have the ability to lock in a favorable variable or even fixed rate (although this is less in vogue nowadays amongst lenders).
Since interest rates on private student loans are based on your credit score, you may be able to get a lower interest rate through a private consolidation loan if your credit score has improved significantly since you first obtained the loan. For example, if you've graduated and now have a good job and have been building a good credit history, your credit score may have improved. If your credit score has increased by 50-100 points or more, you may be able to get a lower interest rate by consolidating your debt with another lender. You can also try talking to the current holder of your loans, to see if they'll reduce the interest rate on your loans rather than lose your loans to another lender. If you are considering this option and you have consolidation terms from lenders, you can use this calculator to calculate how much you will save over the long haul.
There are a few things to keep in mind when consolidating loans through a private lender. First, you should never consolidate both private and federal loans. Consolidating both types of loans excludes borrowers from many of the federal protections/generous payment terms that come with federal loans. You should note if there are any up-front fees for such consolidation, and whether there are prepayment penalties (if you want to pay the loan off sooner, what is the “cost” of doing so?).
A strategy that has become popular in the recent low interest environment has been the use of a home equity loan/HELOC in order to pay off their student loan debt and save money on the interest rate differential. In today’s environment, this can sometimes lead to significant savings, particularly where there is significant private debt. Generally, the deduction you/your parents will receive on a home equity loan/HELOC is far greater than the deduction you may receive for student loan interest.
Before you run out and put debt on your (or your parent’s) home, there are a few things to keep in mind. While you may be able to save a few points on the debt, you are putting your home at risk. You are also losing some of the federal benefits/protections (explained below). You also may want to consider the type of rate; if it is a variable rate home equity loan/HELOC, you would be trading a fixed rate in federal loans for a variable rate loan. However, if you/your parents have the means to pay off the debt if interest rates tread higher, this may not be a bad option.
In next month’s article, we will discuss some additional strategies that can be used to get yourself out of debt, as well as direct you to some of the resources you should take advantage of. Stay tuned!
Karen DeRose and Anthony DeRose are registered representatives of Lincoln Financial Advisors Corp.
Securities offered through Lincoln Financial Advisors Corp a broker/dealer (Member SIPC) and a registered investment advisor. DeRose Financial Planning Group is not an affiliate of Lincoln Financial Advisors Corp. Lincoln Financial Advisors does not provide legal or tax advice.