By Joseph Reinke, CFA, CEO of FitBUX
When it comes to Federal income driven repayment (“IDR”) plans for student loans, everyone from ‘Financial experts’ to your peers have differing opinions. At FitBUX, we have a different opinion. We believe that all financial products have a purpose. If used for that purpose, the financial product is extremely useful. If misused, the result can be costly. This article discuss two large mistakes we see people making when they come to us for student loan help.
IDR Mistake #1
The costly and easily avoidable mistake is recertifying your income. Recertification is when you submit your income each year to your loan servicer. They then use that income to determine your monthly payments for the next 12 months. If you do not submit you earnings on time, your monthly payment will increase. The amount of increase depends on which IDR plan you are on. However, that is not the critical part. If you do not submit your earnings on time your interest is capitalized. In plain English, this means the interest that has accrued will now be charged interest. In other words, you will be charged interest on top of interest. According to the Bloomberg, almost 24% of borrowers on IDR plans fail to recertify their income. To illustrate the cost of this mistake I will use this simplified example: – You owe $100,000 at the time you go onto a Federal IDR plan. – The interest rate on the loan is 6.0%. – Your Federal IDR plan forgives the balance and accrued interest after 20 years, at which time you will owe taxes on the amount forgiven. – The monthly payment under the Federal IDR plan is $300 per month. For simplicity, we will assume that your income does not grow during the 20 years.
Scenario 1 – You Recertify Your Income
A loan of $100,000 at a 6.0% interest rate has interest costs of $500 per month. As stated in the assumptions above, the monthly payment on our Federal IDR plan is $300 per month. This means we are deferring $200 per month in interest. In this scenario, we assume the individual sends their annual earnings to the loan servicer each year and the loan is forgiven in 20 years. At that time the amount forgiven is $148,000 ($100,000 for the loan amount plus $48,000 in accrued interest). At a 35% tax rate, the individual in this scenario would pay $51,800 in taxes when the loan is forgiven.
Scenario 2 – You Don’t Recertify Your Income
In this scenario, we assume the same assumptions as above. However, let’s assume that in year 10, the individual does not submit his annual earnings to the loan servicer. At that time he would have accrued $24,000 in interest, which then becomes capitalized. That means the balance of the loan is now $124,000 and the full amount is charged interest. At a 6.0% interest rate, the monthly interest would be $620. We will assume that the individual corrected this mistake within a month and went back onto a Federal IDR plan. Therefore, the required monthly payment remains at $300, but the individual now defers $320 in unpaid interest per month. In 20 years, the amount forgiven would be $162,400 ($100,000 for the loan amount, plus $24,000 of interest for first 10 years, plus $38,400 of interest for the last 10 years). The resulting tax payment at a 35% tax rate would be $56,840, or $5,040 more than in Scenario 1 or almost 10% more.
IDR Mistake #2
There are many risks associated with using an income driven repayment plan. Most, if not all, of these risks are mitigated by….saving the money you aren’t paying. However, most individuals on IDR drop their monthly payment and use that as an opportunity to spend rather than save. IDR plans have been available for a relatively short period. However, on a daily basis we at FitBUX see individuals constantly encountering this risk associated with IDR plans. Those that saved were able to change their strategy without a problem because they gave themselves options by saving. Those that didn’t save have put themselves in a horrible situation. For example, we had an individual sign-up for help recently who went onto an income-driven repayment plan 2 years ago. His plan 2 years ago consisted of dropping his payment and burying his head in the sand (not a good strategy). Long story short, he recently got married and staying on an income-driven repayment plan no longer makes since. However, he has accrued $16,000 of interest. He didn’t save any of the money and its going to take him about 10 years to repay his loan. That means he cost himself an additional $5,000! If he would’ve saved the money he wasn’t spending, he could’ve used his savings to make a prepayment and pay off the $16,000 of accrued interest. Therefore, saving the $5,000
Avoiding this mistakes will save you thousand and reduce the risk of IDR. Recertify your income and save money. If you need help figuring out how much to save as well as want someone to hold you accountable, be sure to check out our new IDR Tax Savings Solution.