Wealth Club: How to Navigate the Grad School Debt Dance

In our financial advice column for the centsless, Michael Fleck fields questions on how to get your money right.

Today, recent college graduates carry an average student loan debt of about $25,000. We’re in our 20s and 30s and, if we’re lucky, we have jobs that pay well enough to cover rent and bills with enough left over to have a little fun—and, of course, save.

I say ‘we’ because with more than $60,000 in federal and private debt that financed my undergraduate and master's degrees, I’m in the same boat as many of you. Shifting our net worth from the red to the black isn’t easy when we've got student debt, but if your plan includes a graduate degree, today’s Wealth Club will help you begin to understand the possibilities and consequences of borrowing money for even higher education.

Pre-approving yourself before going back to school

Think hard about the implications of incurring new debt. Think twice as hard if you’re already paying undergraduate debt: While going back to school can be a tempting because you can stop your monthly payments on federal undergraduate debt, compound interest could keep your obligations growing while you study. If you’re currently not paying your undergraduate debt but should be, stop thinking about it altogether. There’s a possibility that you’re in default and you should get that house in order first.

It took me four years after graduation before I took the plunge and returned to school. I don’t regret the wait, but not everyone has that luxury, especially if your graduate degree is a formal (or even informal) requisite for your career path. Unless you have the funds to pay for graduate school in cash, consider a scenario in which taking on such a massive amount of debt actively harms you once you graduate. Be sure you really want to pursue your chosen field. If it doesn’t interest you, then it damn well better help you make more money in the job you already have.

Finding the right type of aid

The federal government has various programs to help people pay for their graduate education. Some monies are sent directly to the university in the forms of grants, work study opportunities, and Perkins loans. There’s also the Stafford program, which, like the undergraduate Stafford, provides relatively low-interest loans, both subsidized and unsubsidized, to those who qualify. The main difference is that for subsidized loans, the government picks up the bill for interest that accrues during the deferment period. Stafford loans most likely won’t cover all of your tuition expenses, but they are a nice start. Finally, there's the Direct PLUS loan program, which is open to a broader array of students and has higher borrowing limits, but also a higher interest rate.

Private student loans are a different ballgame. The amount you can borrow is higher, the payment schedules may be more flexible, and the rules for loan proceeds are generally less stringent. But the interest rates will most likely be higher, you may encounter fees, and the rules of the game are much less transparent.

Paying it back both during and after

When you return to graduate school, your federal undergraduate loans are deferred. While in deferment, no monthly payments are due until up to six months after you graduate, but the balances don’t necessarily freeze. If the loans are unsubsidized, interest continues to accrue. Each month, interest is calculated and tacked onto the balance, a process known as capitalization. Over the 24 months it may take you to finish grad school, a $25,000 balance at 5 percent will grow to roughly $27,624. If the loans are subsidized, the balances just freeze. Deferment sounds great, and in many cases it’s helpful, but it comes at a cost. WEALTH CLUB RULE: If you’re in deferment, and have some extra money that you want to put towards outstanding student debt, apply it to any unsubsidized loans before any subsidized loan.

There are three main repayment plans that can be used for undergraduate and graduate student loans. The first is standard, a 10-year plan with monthly payments no less than $50. It’s the shortest term available, and will result in the least amount of interest paid. Next is the extended plan, which can lengthen to term to up to 25 years. A longer term means lower monthly payments, but more interest paid over the life of the loan. You need to have at least $30,000 in debt to qualify. Last is the (punny!) graduated plan. Your payments start small and increase every two years, although the highest payment can never be more than three times any other payment. The diagram below illustrates the difference between the three plans for $35,000 of debt at 6.8 percent, the current interest rate for graduate Stafford loans. Play around with your own numbers. If you can afford the standard plan, do it. It’ll save you money in the long term, and the sooner the better when it comes to eliminating debt.

There are also income-based repayment plans. It’s worth seeing if you qualify for these plans, as they could allow you to have at least some of your total debt canceled. After 25 years of paying what you’re deemed capable of paying, the remainder of your debt is canceled. If you work in public service, that process only takes 10 years.

Turn multiple monthly payments into one

Consolidating your federal loans can be a convenient and prudent option for some borrowers, allowing you to combine your individual loans into just one monthly debt service payment. The government’s page on cancellation and consolidation directs interested parties to the Direct Loan Consolidation Center for more information. You generally cannot consolidate private loans together with federal loans.

I recently called my student loan servicer, Sallie Mae, to ask about consolidating. I was told that it wouldn’t be a good option. Of my four undergraduate Stafford (federal) loans, three have an interest rate of 1.76 percent; the other, 6.8 percent. The friendly woman on the phone informed me that even though the new interest rate is a weighted average, the combined interest rate tends to be a little higher than an actual weighted average. I decided instead to scrounge up the funds to pay off that one pesky, expensive loan.

Why can’t every season be tax season?

As I hinted a few weeks back, going back to school can be quite advantageous for tax purposes. Interest you pay on student loan debt is deductible, even if you take the standard deduction. Depending on if the loans were for undergraduate or graduate, as well as your taxable income, you may be able to use one of three tax treats:

1) American Opportunity Credit-A tax credit, up to $2,500 (reached if you paid $4,000 or more) toward post-secondary education only—sorry graduate students. This is mostly for parents.

2) Lifetime Learning Credit—A tax credit, up to $2,000 (reached if you paid $10,000 or more), which can be used for undergraduate or graduate education expenses. Your taxable income must be under $60,000, but there’s no limit to the number of years you can take it. None of it is refundable, so it can only bring your tax bill down to zero, it can’t get you a refund.

3) Tuition and Fees Deduction—A deduction to your income rather than a tax credit, for those with taxable income under $80,000. You must itemize your deductions to take this.

Default isn’t as dire as you may think

If there’s absolutely no way you’ll be able to pay back your student loans, I’m guessing your money woes don’t stop there. You may be on the brink of bankruptcy, and yes, the nasty rumors are (mostly) true. Student loan debt, both federal and private, is not dischargeable in bankruptcy. Unless you can show a court—through a totally separate proceeding than the actual bankruptcy hearing itself—that paying back your student debt would put an “undue burden” on you and your dependents, it won’t be discharged. If you’re living under a bridge eating dented cans of tuna—not the tuna, the actual cans—there may be a light at the end of the tunnel, as long as these loans are causing you to be unable to afford basic human needs. Otherwise, you own these loans, and they’ll need to be paid back. So don’t wait. Find the right payment plan and build it into your monthly budget. Now, go learn something!