In my last post, I demonstrated how taking just $5 dollars per day from spending and putting it toward paying down your debt could have you out of debt in a surprisingly short time. One reader wrote back that she would never put extra money toward paying off her student loans. She wasn’t able to break even with her payments, and she felt paying extra on the them was like simply lighting her money on fire.
I could see both the frustration and despair in her words. And it was clear that she couldn’t see how the extra payments could make a difference.
The huge balances some carry can make it seem like you’ll never get out from under your debt.
Student loans are complex, and the myriad of repayment plans can make it harder to make a dent in your balances. In 2007, new student loan repayment plans were introduced on federal loans to help indebted graduates better afford their payments. These plans are based on a percentage of your income, and extend the repayment period. The payments are lower than the standard ten-year repayment term.
But in some cases, these extended payment plans can have you paying less than the total interest that is accruing on your loan. You aren’t making any progress on reducing your loan amount, and interest continues to grow. That was the case with the reader who wrote to me.
The Consumer Financial Protection Bureau found that half of student borrowers are in their mid-thirties before they begin repaying their loans and 30 percent are not reducing their balances after five years of payments. Unless you want to make payments on your student loans for much of your working life, you eventually need to be paying enough to cover all the interest and some principal every month.
Debt payments take away your flexibility. You must maintain a larger emergency fund, because your monthly obligations are larger. You may find it difficult to do other important things like save for retirement or college for your own children. Your financial security rides on you getting out of debt.
So it is worthwhile to make extra payments on your student loans. If you can’t afford the payments under the ten-year standard repayment plan, and therefore need a longer repayment schedule, pay as much as you possibly can anyway. Your goal is to cover all the interest and some principal.
With each principal payment the next month’s interest will be lower, and your next payment will include more principal. With more principal covered, the next month’s interest will be lower still. It becomes a virtuous cycle that get’s better with each passing month.
If you can direct windfalls, like a tax refund or bonus from work, to pay down your principal, you can give your repayment plan a boost. If you can increase your extra payments over time as your income increases, you can make even faster progress.
You may be thinking, why bother. These income based repayment plans come with debt forgiveness after twenty years. Why should I make extra payments?
Aside from the advantages of eliminating debt payments from your monthly budget, the forgiven loans will still cost you. While the student loan arm of the government may forgive your debt, the IRS will not. The full outstanding balance will be considered income in the year it is forgiven, and you will owe income taxes on the forgiven amount.
There is one exception to all of this. If you qualify for the Public Service Loan Forgiveness program, your loan will be fully discharged after ten years with no tax implications regardless of how much principal is remaining. So if you are in this program and can stay in public service for the full ten years, there is no reason to make extra payments on your student loans.
For everyone else? Pay as much as you can. Take drastic measures if you need to, but cover all the interest and at least some principal with each loan payment. Paying extra is not futile, it is necessary. Your financial freedom depends on you getting out of debt.
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For a comprehensive, step-by-step guide to building your own financial plan, pick up my book, “Save Yourself; Your Guide to Saving for Retirement and Building Financial Security”. It is now available on Amazon.