Source: Flickr user KitAy.
If you're one of the millions of Americans with federal student-loan debt, your monthly payment can be an unwelcome burden, and the low-payment options on offer may seem tempting. However, there's one good reason you should choose the most expensive monthly payment option you can afford: the interest you'll end up paying.
Student-loan repayment options
When you repay your federal student loans, you have several choices of repayment plans, which you can change periodically. The most commonly used options are:
- Standard: Spreads your student loans over 10 years of equal payments. Unless you apply for one of the other payment options, your loans will automatically be placed in this plan after you finish school.
- Graduated: Also spreads your loans over 10 years, but your payment starts out small and gradually gets larger. Intended for people who are expecting their salaries to increase significantly in the early part of their careers.
- Extended: Spreads your student-loan balances and interest over a 25-year time period of equal payments. To qualify for an extended repayment plan, you must have more than $30,000 in federal student loans.
- Extended graduated: A 25-year payment plan whose payments start small and increase over time.
- Income-based repayment: Known as IBR, this plan limits your monthly payment to 25% of your discretionary income, which is defined as the difference between your income and 150% of the poverty guideline where you live. After 25 years of on-time payments, any remaining loan balance is forgiven, and your payment will never be more than the standard 10-year payment amount.
- Pay as you earn: The newest repayment plan is available only to borrowers who took out their first loan after Oct. 1, 2007, and received at least one loan disbursement after Oct. 1, 2011. This plan is similar to IBR but limits your payment to just 10% of your discretionary income and forgives any remaining balance after 20 years.
Consider the total cost
Let's look at an example of a recent graduate with $35,000 in student-loan debt, and what this would translate to with each of the repayment options. For the income-dependent payment plans, we'll assume that the borrower earns a starting salary of $40,000 per year and receives 5% annual pay increases for the duration of the loan (yes, this is optimistic, but it's the assumption the Department of Education uses).
| Repayment Plan | Initial Payment | Final Payment | Total of Payments | Interest Paid |
|---|---|---|---|---|
| Standard | $389 | $389 | $46,629 | $11,629 |
| Graduated | $222 | $667 | $49,742 | $14,742 |
| Extended | $226 | $226 | $67,652 | $32,652 |
| Extended graduated | $175 | $339 | $73,601 | $38,601 |
| Income-based (IBR) | $217 | $389 | $53,773 | $18,773 |
| Pay as you earn | $145 | $389 | $66,293 | $31,293 |
Note: Assumes average student-loan interest rate of 6%.
Even though you can probably qualify for a lower monthly payment than the standard amount, the most expensive option will cost three times the interest of the standard repayment plan. Of course, this is a simplified example, and the difference between repayment options for you will vary depending on your loan balance and income level, but the same principle applies. To compare the repayment options for your loans, the Department of Education provides a payment estimator here.
Which repayment option is best for you?
Bear in mind that many people do have good, legitimate reasons for choosing one of the lower payment options. For example, if you work in public service and will be eligible for forgiveness after 10 years of payments, it makes sense to pay as little as possible through either the IBR or pay-as-you-earn plan. And if you have reason to believe that your salary will increase dramatically throughout your career (many medical professionals fall into this category, for example), a graduated repayment option may be the most practical choice for you.
The point is that if you can afford it and you have no reason not to, it could greatly benefit your long-term financial health to choose the most ambitious repayment plan that you can reasonably fir into your budget. You may feel a bit of a squeeze at first, but you could save yourself thousands in interest over the years.
