By Joseph Reinke, CFA, CEO of FitBUX
Every financial product has its purpose and if used correctly can be an effective component of your personal finance arsenal. However, many using Federal income-driven repayment (“IDR”) plans are misusing them. This article discusses one of the ways they are often misused. The following quote from Facebook highlights this misuse:
“I spoke to my uncle who is a financial advisor. He told me the best Federal repayment plan was to go on IDR and make the minimum payment. Then each month, take my savings and use all of it to pay down the highest interest rate loan first. That would save me the most money in the long-run.”
Working With A Student Loan Expert
This quote highlights why you need to be working with a student loan expert when developing your student loan repayment strategy. Although the intention of the above quote is good, it demonstrates a lack of understanding of how IDR works.
If you make the minimum payment, you are most likely not paying enough to cover the interest expense accruing on your loans. This is especially likely if you graduated within the last three years. Since your monthly payment does not cover the interest charge on your loans, you are deferring interest each month and accruing it to the amount you owe (i.e., your outstanding loan balance will continue to grow until your income based payments are higher enough to cover the interest charge).
Even if you wanted to make payments that are greater than the minimum amount due and apply those “prepayments” to the highest interest rate loan first, you won’t be able to. Federal law mandates that your payments go first to paying down accrued interest, before it can be applied to the principal balance.
Therefore, if you are using IDR to “pay down the highest interest rate loan first,” there is no reason to use IDR. You would be better off taking advantage of other Federal loan programs and/or refinancing your loans with a private lender. Other Federal repayment programs you can use include extending your loans and making prepayments or going on a graduated repayment plan.
An Easy Way Too Customize Your Repayment Strategy
The technology we are building at FitBUX gives you the ability to compare various student loan repayment strategies that are customized to you. If you would like to test the technology for free, sign up to be part of our beta test.