Friday, June 8, 2012

Making Student Loan Payments Sting Less

The Obama administration has made it easier for those repaying their student loans to shift into the income-based payment plan. This plan limits payments to a fixed percentage of a borrower's discretionary income (currently 15%, dropping to 10% in 2014). Any remaining debt is forgiven after 25 years.

Income-based payment a good choice for recent graduates who are getting settled into the labor market. In fact, I think it should be the default option, rather than the 10-year payment plan that is currently the standard. The current default makes little sense from an economic perspective - earnings are lowest and most uncertain when a graduate first enters the labor market, so why shove all the loan payments into those years? A college education pays off over a lifetime, so it makes economic sense to pay for that asset over a long horizon.

How different is the income-based repayment from the standard plan? For a graduate coming out of college with $22K in subsidized Stafford loan debt, and earning $30,000 a year, the standard ten-year repayment would be $217 at an interest rate of 3.4% (the current rate) or $253 (if the rate goes up to 6.8% in July, as scheduled). With the income-based plan, the payment would be only $165, no matter what happens to the interest rate. The borrower is free to pay more per month should she find some extra money lying around and wants to knock the debt back more quickly.