A common repayment strategy: Small returns and big consequences



On the floor of the Senate last June, Sen. Lamar Alexander compared student loans to car payments. While financial aid experts argue this comparison is inappropriate, debt counselors have inadvertently promulgated similar misinformation. By adopting debt management advice that applies to private markets and repurposing it for federal student loans without evaluating its usefulness, many borrowers may be missing out on generous repayment options like IBR and consolidation.

Survey data released earlier this month by New America about the way students plan to manage their debt after graduation confirms that new borrowers are not always knowledgeable about the benefits of federal repayment options. Nearly two-out-of five students who are either recently enrolled or are making their way through the college decision process said that paying down high interest debt before lower interest student loans was a good  repayment strategy. Meanwhile respondents ranked options like consolidation and Income-Based Repayment (IBR) that often reduce monthly payments much lower, with just 18 and 22 percent choosing each of these, respectively.  

In the category of random life advice that you probably learned from your uncle, most people have heard that they should pay down whichever debt carries the highest interest rate first. By adopting this strategy a borrower should save significantly in interest since he will more quickly pay off his principal and decrease the total number of payments he has to make.

But while prioritizing high interest debt may be worthwhile for credit cards and auto loans where rates can vary widely — federal student loans are different. For students managing loans with interest rates that typically differ by only a few percentage points, the savings to be gained from using this strategy are minimal. Worse still, taking this approach may be making life more difficult for many borrowers given that they have to keep up with payments that are not always affordable and interact with multiple loan servicers.

Respondents’ choices are concerning, but they are not necessarily surprising. IBR can be confusing for borrowers who are uncomfortable with not knowing upfront how much they will be expected to pay per month. Furthermore, nebulous terms like “disposable income,” and incorrect assumptions that loan forgiveness after 20 years necessarily means that borrowers will be paying a percentage of their income for that long can make IBR sound grim. Consolidation may also sound unappealing given that it extends the terms of a loan. But the fact is these are often better options for struggling borrowers.

Consider someone making $35,000 per year who has two loans. Each is $10,000, but one carries a monthly interest rate of 7.2 percent and the other, 4.6 percent. Both are to be repaid under the standard 10 year plan. Having just graduated from college, his loans have come due, but he is still struggling to get by with a $220.00 monthly standard payment. Eager to get rid of his debt, he heard that if he pays off the loan with the 7.2 percent interest rate faster, he could save a lot in the long run. But the savings are negligible. For example, if he chose to contribute an extra $50.00 a month over his minimum payment to the higher interest rate loan instead of devoting $25.00 to each, he saves just 10 cents  per month in interest. On the other hand, he could be taking advantage of options like consolidation or IBR to lower his monthly payments. If he were to consolidate his loans, he extends the terms by several years, but manages to pay $22.05 less per month than if he paid the loans separately. If he pursues IBR, his monthly payment would be $97.00 less.

To be sure, if students are successfully making payments on time as the majority are, and they want to pay off their loans faster, while saving a buck or two per month with this repayment strategy, it shouldn’t matter. Unfortunately, the exaggerated benefits of this strategy come at a high cost when it prevents struggling borrowers from considering other, better options. While 7.5 million student loan borrowers are in default, many more are at least occasionally missing payments, and almost all are dealing with some degree of unnecessary complexity. IBR essentially offers free insurance in case things go wrong. Students can pay above the minimum if they wish, but their payments will never be more than ten percent of discretionary income.

Borrowers should not be led to believe that paying down student debt with different interest rates is the only, or even the best option. Arguments against automatically enrolling borrowers in IBR — that it is not right for everyone — miss the point entirely. IBR protects borrowers from having unmanageable debt, but it still gives them the flexibility to pay how they choose.  

When students have the option to guarantee that their monthly payment will be manageable through IBR but still plan to use strategies that sometimes only save them a few cents per month, they put themselves at a disadvantage. Maybe IBR needs a better elevator pitch. But given the power of misinformation, we should consider going one step further and make it the default option.