Struggling to Pay Student Loans? Here's a Plan That Works

Last Updated Jan 25, 2010 5:16 PM EST

Dear Ray,
I'm trying to figure out what to do with my school loans. I have two loans, both consolidated through Direct Loans. One is $8,000 with an interest rate of 7.5 percent and the other is $35,000 with an interest rate of 2.4 percent. To date, I have had either a deferment or forbearance and have not been making payments. I would like to start paying these off, but monthly the amount due for both loans together is about $300, which is too much for me to handle right now. Which loan should I start paying off, and can I pay on one and keep the other in forbearance? Also, what type of repayment schedule should I be on? The options are standard, extended fixed, extended graduated, graduated, ICR (income-contingent repayment), IBR (income-based repayment). I have no idea which one to choose, even after reading the descriptions. If you can offer any advice, I would really appreciate it.
Struggling to Pay Student Loans
Dear Struggling:

Here is the reality: there is no statute of limitations for collection of student-loan debt, and lenders have very strong powers to collect on defaulted student loans. For instance, lenders can garnish up to 15 percent of your take-home pay, seize your federal and state tax refunds, and prevent renewal of professional licenses. So folks with student loans need to realize that paying back student loan debt is a financial priority. There are also financial incentives to paying back student loans: You can deduct up to $2,500 in student loan interest, even if you don't itemize deductions on your income tax return.

The first thing you need to do is to immediately speak with your lender and/or a representative from the Department of Education. Why? If you default before contacting your lender, you may become ineligible for continued deferments or forbearance. I did some checking on my own, and I believe they will tell you that you can make payments on one loan and keep the other loan in forbearance.

Lenders may offer deferments for up to three years for federal loans and one year for private loans. They may also offer forbearance. Here's how these work. In deferment, the interest on subsidized federal loans does not have to be repaid, but the interest will continue to accrue for unsubsidized loans. In forbearance, you may be permitted to reduce or stop making payments for a set period of time, but the interest continues to accrue. These options should only be used for the short term. If a loan is in deferment or forbearance, make every effort to at least pay any accruing monthly interest. If you don't you'll end up paying interest on the unpaid interest, which is just a plain dumb thing to do!

A new payment option made available last year for federal loans is the Income Based Repayment (IBR) plan. Under the IBR, the payment is capped at 15 percent of discretionary income (defined as income that exceeds 150 percent of the poverty line). Under this option, any loan balance that remains after 25 years of payments can be forgiven. This option may be available even if you have already defaulted on your loans. This option may be suitable for folks with high debt, low incomes, or low near-term prospects of getting a higher paying job. This may be the best repayment option for you.

Finally, paying off the loan with the highest interest rate first is the best path forward. Assuming the $8,000 student loan is the highest-rate debt you have (no credit card debt, right?), work on paying this down first . Take a second job to bring in additional income if possible, and use it to get this $8,000 loan paid off as fast as possible. When that loan is paid off, use the payments you were making on it and direct that toward paying down the next loan. This will create a snowball effect; when one high-interest-rate debt is paid off, you can more payments on the next loan, which will be paid off more quickly. This is a plan that works.
  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.

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