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The Road to Being Debt-Free: Two Smart Paths for Student Loan Borrowers

March 3, 2016
Loans, Student Loans
The Road to Being Debt-Free: Two Smart Paths for Student Loan Borrowers
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The road to getting rid of your student loan debt may feel like a long one, but there are ways to cut your commute.

Income-driven repayment plans and student loan refinancing are two options that can help you manage your student loans. The former can lower your monthly payments, and the latter can save you money in interest (sometimes lowering your monthly payments) and potentially decrease the time it takes to become debt-free. Both can be good choices for borrowers, but each has some downsides, too. Here’s a breakdown of when to choose each strategy.

The basics

Income-driven repayment: Income-driven repayment plans are federal programs that allow you to cap your monthly payments at a percentage of your income and get your remaining loan balance forgiven after 20 or 25 years of making payments. Income-driven plans include the new Revised Pay As You Earn (REPAYE), the Pay As You Earn (PAYE) and the income-based repayment plans. The only catch is that with each of these, you’ll end up paying more in interest over time because the plans extend your loan term. Learn more about choosing the best student loan repayment plan.

Student loan refinancing: Student loan refinancing is the process of taking out a new private loan to pay off existing federal or private student loan debt at a lower interest rate. The wrinkle here is that when you refinance federal student loans, you lose important borrower protections that the government offers, including the ability to enter deferment or forbearance if you lose your job or get sick. You also lose access to income-driven plans and federal forgiveness programs.

When to switch to an income-driven repayment plan

If you feel like you’re drowning in bills, a lower monthly student loan payment through an income-driven repayment plan could give you the breathing room you need to meet your other obligations. Additionally, if you’re planning to apply for Public Service Loan Forgiveness after working for a nonprofit or the government for 10 years, making payments on an income-driven plan will save you the most money. While some income-driven plans require that you have a financial hardship in order to qualify, REPAYE is available to all borrowers with federal direct loans.

Given that income-driven repayment plans increase the amount of interest you pay throughout the life of the loan, you shouldn’t necessarily switch to one if you can afford your monthly payments on the standard 10-year plan.

When to refinance your student loans

You’re not eligible for federal income-driven repayment plans if you have private loans. If this applies to you, refinancing is your best shot at saving money in interest or lowering your monthly payments.

If you have federal student loans and don’t want to utilize income-driven repayment or a federal forgiveness program, refinancing is a way to save money on interest — especially if you want to pay off your student loans fast.

“We really see people that are trying to accelerate their repayment,” says Alan Cooper, head of communications at student loan refinancing company Earnest.

However, it may be wise to stay on the standard plan instead of refinancing; you’ll maintain the option to switch to an income-driven plan or take advantage of other federal protections if the unexpected happens.

“You may get hit by a bus and be totally disabled and not able to work anymore,” says Persis Yu, director of the Student Loan Borrower Assistance Project at the National Consumer Law Center. “Federal loans will have discharge options.”

Although that’s a worst-case scenario, Yu’s point is valid: Refinancing your federal student loans is a risk. Still, it could be one worth taking if you’re determined to pay off your student loans fast and save the most money.

In practice: Income-driven repayment vs. student loan refinancing

Here’s an example to help bring this decision to life: Say you have $28,950 in student loans, which is the average student debt for the class of 2014, according to the Institute for College Access & Success. They’re federal direct unsubsidized loans and have an average interest rate around 6%. Let’s also assume you earn $50,000 and your salary increases 5% each year.

In this example, the choice would come down to this: Do you want to lower your monthly payment or save the most in interest over time?

Switching to the income-driven plan, REPAYE, would give you the lowest initial monthly payment and allow you to pay off your loans the fastest. But it would also have you paying the most over the life of the loan. Refinancing to a 5% interest rate would lower your monthly payment slightly compared with the standard plan and would save you the most in interest over time. Note that depending on your total student loan debt, your income and your interest rate, the differences in what you would pay on various repayment plans could be more striking than in this example.

 Monthly payment
Total amount paid throughout the life of the loan
Number of payments
Standard plan$321.41
120 (10 years)
REPAYE (income-driven plan)$270-$466
110 (9+ years)
(reduce interest rate from 6% to 5%)
120 (10 years)

Next steps

If you’re interested in switching to an income-driven repayment plan for your federal student loans, use the Department of Education’s Repayment Estimator to compare the different plans. You can plug in your income, interest rate and total student loan debt, and compare your options in a chart similar to the one above. After you decide which repayment plan is best for you, apply through your student loan servicer.

If you’re interested in refinancing your student loans, you should compare several rates before choosing a lender. You can fill out one application and get rates from several lenders through Credible, a student loan refinancing platform that NerdWallet partners with.

Teddy Nykiel is a staff writer at NerdWallet, a personal finance website. Email: [email protected]. Twitter: @teddynykiel.

Image via iStock.