Are Your Student Loan Payments Higher Than Necessary?

Source: Tulane Public Relations via Flickr.

If you're among the millions of Americans who make student loan payments each month, it's important to know all of the repayment options available to you. Certain plans could lower your monthly payments, freeing up more of your cash.

Here's an overview of the most advantageous repayment plans, along with the pros and cons of reducing your payment.

The Pay As You Earn plan
The Pay As You Earn is designed to keep your payments low when you're fresh out of school and not earning much money. Then, as your income grows, so do your repayments.

The required payment amount is actually quite low: It's capped at either 10% of your discretionary income or what your payment would be under a standard 10-year repayment plan. For the purposes of this calculation, your discretionary income is the difference between your income and 150% of the poverty guidelines for your family size and state of residence.

As an example, let's say you earn $60,000 per year, live in any of the 48 contiguous states or Washington, D.C. (the poverty guidelines are only different for Alaska and Hawaii), and are married with one child (family size of three). The poverty guideline for 2015 is $20,090, and 150% of that amount is $30,135. Therefore your discretionary income is $60,000 minus $30,135, which comes to $29,865. Divide this over 12 months and apply the 10% rule, and you can see that your monthly payment would be capped at about $250, no matter how high your student loan balance is.

Now, the most common concern I hear is that such a low payment may not even cover the interest on the loans, and therefore it could take decades to pay off the balance. However, under the Pay As You Earn plan, any remaining loan balance will be forgiven after 20 years of on-time payments, regardless of how much is left.

It's also worth noting that Pay As You Earn isn't available to all borrowers yet. It was announced last year that the program will be available to all borrowers by the end of 2015, but for now it's only open to borrowers who took out their first loan after October 2007. For those who are currently ineligible, the Income-Based Repayment, or IBR, plan, offers similar benefits: The payment cap is slightly higher at 15% of discretionary income, and any remaining balance is forgiven after 25 years.

Extended repayment
If you'd prefer payments that stay the same over the years but find the 10-year repayment plan a little too expensive, there's also the option of an extended repayment plan, which spreads your payments over a longer time frame (up to 25 years). This tends to be an appealing option for people who earn too much to take full advantage of the Pay As You Earn plan but find the 10-year payment amount to be too high to manage along with their other expenses.

Another advantage of the extended option is that your loan balance will go down over time, which can provide a nice boost to your credit score. According to the FICO scoring formula, 30% of your score comes from "amounts owed," which takes into account, among other things, the remaining balances on your loan relative to the original loan amount.

The downsides of choosing the extended repayment plan are that you'll never be eligible for loan forgiveness as you would with the Pay As You Earn plan, and you'll end up paying a lot more interest over the life of the loan than you would under a standard 10-year repayment plan.

For example, if you owe $35,000 in student loans at 6% interest, your monthly payment under the standard 10-year plan would be $389 per month. So, over the life of the loan, you'll pay $11,680 in interest. However, if you choose to pay it back over 25 years, your monthly payment falls to about $225, but you'll end up paying $32,650 in interest.

The downside to lower payments
As with anything else in life, there are pros and cons to all repayment options, including Pay as You Earn and extended repayment. As I mentioned before, you'll end up paying more interest with an extended repayment plan than with a standard repayment plan, and if your income increases over the years, this could be the case with Pay As You Earn as well.

And with Pay As You Earn, remember that your payments will rise in proportion to your income, and this could cause a rather sharp increase if you get a raise or a higher-paying job. In the earlier example of a borrower who earns $60,000 per year, a promotion to a job paying $80,000 per year (33% raise) would increase the allowable loan payment from $250 to $415 (67% increase). With a raise that size, a higher loan payment isn't the end of the world, but it's definitely something to keep in mind.

Aside from these drawbacks, the Pay as You Earn plan and the extended repayment plan can be excellent ways to manage your student loan expenses while still building up a solid payment history.