The Guidepost
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Taking Control of Your Debt

Welcome to Lesson 2 of Financial Health 101: Debt and Student Loans, a free short course from Justworks.


 

Lesson 1 | Lesson 2 | Lesson 3 | Lesson 4 | Lesson 5

Welcome to Lesson 2 of Financial Health 101: Debt and Student Loans, a free short course from Justworks.

If you thought Lesson 1 was fun, wait ‘til you see what we have in store for you. The main theme is debt. More specifically, how to create a plan of attack for knocking off debt the right way.

What we’ll cover:

  • A 3-step approach for getting your financial health on

  • How to prioritize debt

  • Repayment options for federal and private student loans

  • Some products and tools you should know about

Let’s do this.

 
 

 
 
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No, not the dance. That’s another course. This 3-step is a simple but effective approach to achieving financial health. That’s not to say it’s easy - building a solid financial foundation is no walk in the park. But it can be a lot easier to manage with the right plan.

So, here it is - the 3-step:

  1. Knock off debt, starting with bad debt. It’s more expensive and can hurt your credit score. Later in this lesson, we’ll share some strategies for prioritizing what to pay off and when.

  2. Don’t accumulate any more bad debt. Avoid being in a situation where you are forced to borrow money at a high interest rate. Pay bills on time. Live within your means. Save for emergencies. Personal budgeting will be your friend for this.

  3. Get a start on retirement savings. Yes, even in your ‘20’s. In fact, that’s the best time to start. We have some ideas for where to begin.

Nail these basics, and everything else is gravy. If you find yourself with additional cash, you can pay off student loans early, start investing, or save for a big purchase, like a home - all from a position of strength and confidence.

The rest of this course is devoted to diving into each step in more detail.

Now, let’s dig into the first, knocking off debt.

 
 

 
 
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As you read in Lesson 1, not all debt is created equal. Bad debt, such as money owed to credit card companies, usually comes with a higher interest rate, which means it’s more expensive. If you miss payments, increase the balance owed on credit cards, or accumulate too much bad debt, your credit score will take a hit. And that can make it harder for you to reach your financial goals.

Here are two prioritization strategies that can help you create a plan of attack for knocking off debt the smart way:


Debt Avalanche

With this approach (also known as debt stacking), debt is prioritized by interest rate. Here’s how it works:

  1. Pay the minimums on all of your accounts.

  2. Put any remaining money towards the account that has the highest interest rate.

  3. When that account is paid off, focus on the account with the next highest interest rate.

  4. Repeat steps 1-3 until all debts are paid off.

Pro: You’ll save money on interest in the long run.

Con: It could be a while until you completely pay off any one account.


Debt Snowball

With this approach, debt is prioritized by balance. Here’s how it works:

  1. Pay the the minimums on all of your accounts.

  2. Put any remaining money towards the account with the lowest balance.

  3. When that account is paid off, focus on the account with the next lowest balance.

  4. Repeat steps 1-3 until all debts are paid off.

Pro: It feels great completely paying off a debt. The psychological benefit might just be the motivation you need to stay on track with your overall plan for financial health.

Con: You might pay more in interest.

Tip. You know yourself best. If you are someone who benefits from positive reinforcement, the snowball method might be the way to go. But, if you are more motivated by saving as much money as possible, then go with the avalanche method. Either way, paying off your minimums each month is always the priority.

 
 

 
 
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In addition to prioritizing your debt, it’s also worth investigating any options you might have for improving the terms of your student loan repayment plan. Depending on your student loan type and other factors, such as income, field of work, credit score, and payment history, certain repayment plans can offer lower interest rates, a simpler payment process, or the opportunity to reduce what you owe.

Tip. Approach with caution. While some repayment plans reduce the amount you owe each month, they can cost you more in the long run.

 
 


Federal Loan Repayment Plans

Even if you’ve passed grace period, you can still change the repayment plan for your federal loan anytime, for free. Here’s a breakdown of the types of repayment plans potentially available to you.

Basic Plans
These apply to direct, Stafford, PLUS, and consolidation (direct or FFEL) loans.

Standard. This is the plan you are automatically enrolled in when your loan enters the repayment phase, unless you choose something else. It’s made up of 120 fixed payments over a 10-year period. If you want pay off your federal student loan as cheaply as possible, this is the plan for you. Learn more here.

Graduated. This plan starts with lower monthly payments that increase over time (usually every two years). Loans are to be paid off within 10 years. This plan might be a good fit if you are new to the workforce and earning an entry-level salary now, but expect your earnings to rise in the future (because you’re awesome - go you!). Learn more here.

Extended. Under this plan, payments can be fixed or graduated (increase over time), and the loans need to be paid off within 25 years. To qualify for this plan, you must have more than $30,000 outstanding in either direct or FFEL loans. Learn more here.

Income-Driven Plans
These can apply to direct, direct PLUS, Stafford, and direct consolidation loans.

If you’re having trouble making payments on your federal loan, and want to avoid delinquency or default, then an income-driven repayment plan might be a good option. With these plans, your payment amount is generally a percentage of your discretionary income (the money you have left over after paying for necessary expenses like rent, utilities, and food).

Pros: Lower monthly payments. Also, if a loan isn’t fully repaid at the end of the repayment period, the remaining balance is forgiven. (Be aware, though: under current IRS rules, a loan forgiven under one of these plans may be considered taxable income.)

Cons: Because income-driven plans lengthen the term of the loan, you pay more interest in the long run.

Here’s a quick summary of the four plans:

Income-Based Repayment Plan. This plan got a recent update during the Obama administration, so the details are specific to when you took out your federal loan and what your outstanding balance was as of July 1, 2014. Based on this, the payment amount is either 10 or 15% of your discretionary income, and the repayment period is either 20 or 25 years.

 Income-Contingent Repayment Plan. The payment amount is either 20% of your discretionary income, or what you would pay on a repayment plan with a fixed payment over 12 years, adjusted based on your income - whichever is the lesser amount. The repayment period is 25 years.

Pay As You Earn Repayment Plan. The payment amount is typically 10% of your discretionary income. If you do see a rise in your earnings (go you!), the payment amount will never be more than the standard plan amount. The repayment period is 20 years.

Revised Pay As You Earn Repayment Plan. The payment amount is generally 10% of your discretionary income. If your loan is for undergraduate expenses, the repayment period is 20 years. If your loan is for graduate or professional study expenses, the repayment period is 25 years.

 You can learn more about these plans here.

Income-Sensitive Plan
This plan only applies to FFEL loans. Monthly payments are 4 to 25% of your gross monthly income (your total compensation before taxes or other deductions). The actual percentage is based on a formula that can vary from lender to lender, but each monthly payment must at least cover interest. The repayment period is a maximum of 10 years, but you must reapply each year.

Tip. This plan is generally best if you need short-term relief. Monthly payments are reduced in the beginning, but end up increasing over the rest of the 10-year term to compensate. If you think you may need support for a longer period of time, consider an extended or graduated plan. These plans reduce the monthly payment amount by extending the term of the loan.

You can learn more here.

Forgiveness, Cancellation, or Discharge
These are three words that basically get at the same thing: you are no longer required to pay some or all of your federal student loan. Here are some examples:

  • Public Service Loan Forgiveness

  • Teacher Loan Forgiveness

  • Nurse Loan Forgiveness (this can also apply to private loans)

  • Perkins Loan Cancellation

  • Total and Permanent Disability Discharge

  • Closed School Discharge

  • End of Loan Term Forgiveness (with income-driven plans)

Learn more about forgiveness, cancellation, and discharge here.


Deferment and Forbearance

Deferment and forbearance let you hit pause on your student loan payments without hurting your credit score. Generally, deferment is for people who are in school or serving in the military or Peace Corps. Forbearance, on the other hand, is generally for people with temporary financial difficulties. The main difference is that, with forbearance, you are still on the hook for interest payments. In both cases, extending the payment terms means you will end up paying more in interest.

Depending on your situation and lender, there are deferment and forbearance options for both federal and private loans. Keep in mind though, to avoid a hit to your credit score you need to continue paying your loans until you are approved for deferment or forbearance by your lender.

Tip. If you have federal loans, an income-driven repayment plan (outlined above) might be a better option. Like deferment and forbearance, income-driven plans cost more in interest in the long run. However, unlike deferment or forbearance, they have the added benefit of offering forgiveness after 20 or 25 years of repayment.


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You may have heard these terms used interchangeably before. Both replace old federal or private loans with a new loan that has its own terms and conditions. But they are not the same. Here’s what you should know about each, and how to decide if either is right for you.

Consolidation. Think simplification. Multiple loans are combined into a single loan, so you only have to handle one streamlined payment each month.

Refinancing. Think optimization. One or more loans are replaced with a completely new - ideally, much better - loan. The goal is to save money by getting a lower interest rate. When you refinance, you can consolidate at the same time, but that’s not the main point.

If you have multiple federal student loans, consolidation might be a good option. A federal direct consolidation loan allows you to combine your federal student loans into one new loan for free. The term of this plan can be up to 30 years, so monthly payments are generally lower. You will have a new fixed interest rate - the weighted average of the interest rates on the loans being consolidated.

Pros. A simplified payment process. Lower monthly payments. One fixed interest rate means you avoid potential fluctuations in monthly payments (which you might see with a variable-rate loan, in which your interest rate could go up in the future.). Access to new benefits, such as income-driven repayment plans and forgiveness, depending on the federal loans you have.

Cons. With an extended term, you will likely pay more in interest over the long run. Interest rates are fixed and non-negotiable, so you won’t be able to “shop around” for lower rates. If you already have direct loans, consolidation may cause you to lose certain benefits, such as loan cancellation or forgiveness.

Tip. If you apply for a direct consolidation loan, you don’t need to include all of your federal loans. For example, if you’ve been making payments toward public service loan forgiveness on your direct loan, it’s probably makes sense not to consolidate your direct loan along with your other federal loans.

You can learn more about direct consolidation loans here.

If you have one or more private student loans and a good credit score, refinancing could be the right option for you, especially if your private student loans have high interest rates. Refinancing allows you to replace one or more private or federal loans with one new, hopefully  better, loan. It happens through private lenders only. That means you can shop around and find the best interest rate available -  you might be offered a fixed or variable-rate loan. It also means that if you don’t have a good credit score (high 600s+) and a steady income, it could be hard to qualify.

Pros. Opportunity to get a lower interest and save money. A simplified payment process if you are consolidating multiple loans. One of very few options for lowering monthly payments of private student loans.

Cons. If you refinance federal loans, you might lose important protections and benefits, such as forgiveness. Unlike federal repayment plans, a refinanced loan through a private lender follows you to death. You could also end up with a variable-rate loan, which means your interest rate could go up in the future. If you extend the term of your loan, you might pay more in the long run.

Tip. In general, it’s best to keep federal and private loans separate. Switching a federal loan to a private, refinanced loan is irreversible. If you’re considering refinancing private loans, do your homework: look for a lower interest rate than what you currently have, low (or no) application and processing fees, and other terms that will truly save you money. Here’s a great student loan refinance calculator to help you do the math.

There are many banks and other types of private lenders that offer refinancing options. Fortunately, there are some helpful third-party review sites that do the work of all that reviewing for you. Keep in mind that many of these sites use affiliate links to earn commissions off of your clicks.

 
 

 
 
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Ok, this was a long one. If you only remember one thing, let it be this: managing debt can be a lot easier if you have the right plan. We’ve laid out some potential options. Some may be a good fit, others not so much. Either way, you are in control.

Once you have your plan of attack for knocking off debt, you need to make sure you can cover expenses each month and avoid being in a situation where you are forced to borrow money at a high interest rate. In other words, you need to do some personal budgeting. We’ll cover that in Lesson 3.

This material has been prepared for informational purposes only, and should not be relied on for, legal, tax, or financial advice.