*Warning: this is a very long post and delves into finance*
TLDR:
-Federal IDR plans make large debts very manageable
-Choose lower monthly plans for flexibility
-Use REPAYE during residency
-Re-evaluate your financial situation at least every year
Now let's do some (serious) math~
As a resident- Part 1:
You graduate with $350,000 in federal loans and enter a 3 year FM residency. You get paid an average resident salary shown below.
| Resident Pay | After tax | Per month |
PGY1 | 55,200.00 | 43,686.00 | 3,640.50 |
PGY2 | 57,100.00 | 44,870.00 | 3,739.17 |
PGY3 | 60,100.00 | 46,741.00 | 3,895.08 |
As you can see, there isn't a ton of room to make large payments but still some. While in residency, you can make payments or postpone (grace period or deferment). During postponement, interest will still accrue but will not capitalize until after. If you can make payments, however small, doing so will help fight back some of the interest before it capitalizes. For now, we'll assume no payments were made to keep the calculations consistent. I'll talk more about making residency payments in Part 2.
As an attending:
You get an annual salary of $200,000 (conservative 2% raise per year) in California with the following breakdown:
Salary | After tax | Per month |
200,000.00 | 132,101.00* | 11,008.42 |
Other states= +-$5,000 to after tax income. I chose CA since to make our estimates conservative. I think only New York is more heavily taxed, but it depends on your city too. You will probably get a signing bonus (average $32,692 for 2018-2019) that I left it out of my calculation.
You can choose A) private refinance, B) federal repayment, or a hybrid with federal for residency and private after that. For now, we'll look at the first two. I'll talk about the hybrid approach when I discuss residency repayment.
A) Private refinance (at the start of residency):
Refinance will consolidate all of your federal loans into private ones. You can refinance any time you want, but once you do, you permenantly lose out on all federal repayment options. You can also refinance as many times as you like to secure the lowest rate possible; shop around at least once a year. There are usually cash bonuses for refinancing, ranging from $100 to $750 depending on your balance. There are also usually discounts on interest rates for things like auto pay. Below are the average rates for 2020:
(2020) Refinancing Fixed Rates
Available (in years) | Excellent
Credit
(750+) | Good
Credit
(700-750) | Average
Credit
(650+) |
5 | 3.03% | 3.40% | 4.00% |
7 | 3.50% | 3.90% | 4.25% |
10 | 3.75% | 4.10% | 4.75% |
Most people will have average credit so we'll use that to calculate the following payment schedules:
Term | 5 Years | 7 Years | 10 Years |
Rate | 4.00% | 4.25% | 4.75% |
Principal | 350,000.00 | 350,000.00 | 350,000.00 |
Interest charge each year | 14,000.00 | 14,875.00 | 16,625.00 |
Total balance after 3 year residency | 392,000.00 | 394,625.00 | 399,875.00 |
Monthly payment | 7,219.28 | 5,439.58 | 4,192.60 |
Total Payment | 433,156.80 | 456,924.72 | 503,112.00 |
Take home pay | 3,789.14 | 5,568.84 | 6,815.82 |
Choosing a 5YT will have you living like a resident for another 5 year. If you're looking to own a home, you'll have to save up longer or buy a more modest house (or use your signing bonus). You can still make it work, especially if you live in a low COL area. Living with debt for another 2-5 years will add a lot more spending money, but you will pay more in the long run. However, I mentioned in my last post, choosing a lower payment plan allows you the most flexibility. You have the ability to spend on things you need when you need and make aggressive payments when you can afford. You will probably end up paying
a little bit more on the long run, but you'll have options not being tied down to a high monthly. You can even choose 15 and 20 year terms. No right answers here since it will depend on each person's preference and family needs, but I do recommend having the flexibility.
B) Federal repayment:
Interest rates are higher than private, but monthly plans are more flexible and you gain access to loan forgiveness. Deferment/forbearance is also easier to get with federal loans if you hit hard times. Specifically, we'll look at income-driven plans (IDR) where your monthly payment is based on your taxable income (re-certified every year). After 20-25 years (or 240-300 months) of payments, the remaining balance of your loan will be forgiven. You will have to pay the tax on the forgiven amount though. There are other federal plans, like the Standard 10 Year, but I won't discuss those since they are generally inferior (still look at them to see if they might work for you). Public Service Loan Forgiveness (PSLF) uses IDR repayment, but forgiveness is achieved after 10 years instead. We won't look at those, but if you qualify, they usually trump everything else
Sticking with federal loans during residency will give us a balance of $418,936 after residency:
| Beg R1 | Beg R2 | Beg R3 | Attending |
Direct Unsub | 179,777.00 | 179,777.00 | 179,777.00 | 179,777.00 |
6.079% interest | 0.00 | 10,928.64 | 21,857.29 | 32,785.93 |
Grad Plus | 170,223.00 | 170,223.00 | 170,223.00 | 170,223.00 |
7.079% interest | 0.00 | 12,050.09 | 24,100.17 | 36,150.26 |
Total Balance | 350,000.00 | 372,978.73 | 395,957.46 | 418,936.19 |
Below is a breakdown of the most common IDR plans and their schedules. We'll use an average 6.579% interest for simplicity.
| Total Payments | Remaining Balance Forgiven | Taxes Due | Total Cost | Year of Repayment | First Monthly Payment | Last monthly payment | Take home pay Year 1 |
REPAYE
(Revised Pay As You Earn 25 Year) | $572,300 | $435,120 | $174,048 | $746,348 | 2045 | $1,511 | $2404 | $9,497 |
PAYE
(Pay As You Earn 20 Year) | $435,606 | $534,650 | $213,860 | $649,466 | 2040 | $1,511 | $2183 | $9,497 |
IBR
(Income Based Repayment 20 Year) | $435,606 | $534,650 | $213,860 | $649,466 | 2040 | $1,511 | $2183 | $9,497 |
There is another IDR plan called income-contingent repayment (ICR), but it's generally inferior (still look at them to see if they might work for you). IDR plans will have a lower monthly payment to start then slowly increase as your salary increases. You will also need to save up for that tax bomb. The best way is to set aside a little every month in an account where it will grow some interest (and saving a small amount hurts a lot less than paying straight). Even with the tax bomb savings, monthly payments remain low for you to enjoy life.
But wait a sec, the total payments we make with these plans is higher than private refinancing. Well, its a little more complicated than this because a dollar today is not the same as a dollar tomorrow, 5 years later, or 25 years later.
[Warning: it's about to get really technical and finance-y]
Money today is worth more than money tomorrow because you can put it to work and generate some return. If we are to compare apples to apples, we need to compare tomorrow's dollars in terms of today's dollars. In the most common sense, we can invest money today in some sort of financial vehicle so it grows according on the interest and term. If you put $100 in a 1% savings account in 2020, you will have $105.10 in 2025. So that a balance of $105.10 in 2025 has a present value of$100. Conversely, $105.10 in 2024 is not the same as $105.10 in 2025. Think of it like inflation: we can't compare money in different time periods without converting them all into the money from the same time period.
It gets pretty hairy when you're making regular payments. That's because each payment will be made in different time periods. If you make $100 every year for 5 years into a 1% savings account starting in 2020, the 2022 payment will be worth less than 2021 payment because the 2021 payment will have more time to grow. So we have to discount each years payment separately and add them together in order to find the present value of the total investment. Thank goodness we have Excel and calculators out there so we don't have to crunch the numbers for 20 years of monthly payments. Hopefully I explained that well; there are articles and videos out there if I didn't.
So what does this mean for our student loans? Well if we want to really compare the costs of repayment plans, we should calculate the present value of all of their payments. Aggressive repayment will reduce the face-value of total cost, but you are also losing out on investment opportunities. Plugging all of the conditions above with a conservative investment rate of 5%, we generate the following breakdown:
| Total Payments (Until Payoff or Forgiveness) | Remaining Balance
(When Loans Are Forgiven) | Taxes Due (from user input) | Total Cost of Loan Payback | Cost of Payback in 2020 Dollars, aka Net Present Value | Year of Total Repayment or Forgiveness | Monthly Payment | Monthly Tax Penalty Account Savings in Mutual Funds |
REPAYE | $572,300 | $435,120 | $174,048 | $746,348 | $374,720 | 2045 | $1,511-$2404 | $321 |
PAYE | $435,606 | $534,650 | $213,860 | $649,466 | $357,170 | 2040 | $1,511-$2183 | $572 |
IBR | $435,606 | $534,650 | $213,860 | $649,466 | $357,170 | 2040 | $1,511-$2183 | $572 |
Private Refinancing (5 Year Term) | $433,157 | N/A | N/A | $433,157 | $393,822 | 2025 | $7,219 | N/A |
Private Refinancing
(7 Year Term) | $456,925 | N/A | N/A | $456,925 | $396,591 | 2027 | $5,440 | N/A |
Private Refinancing
(10 Year Term) | $503,112 | N/A | N/A | $503,112 | $407,914 | 2030 | $4,193 | N/A |
The NPV of PAYE and IBR have lower payments, including tax bomb savings, and still trump the private 5YT plan. Even an average FM physician graduating with a large amount of debt will have very manageable payments through federal IDR plans. The critical part of these calculations is your chosen investment rate because it affects both the NPV of the plan as well as the amount you will need to save up for the tax bomb. If you choose a lower investment rate, the NPV of all plans will increase. The key will be that longer repayment terms (IDR plans) will increase more dramatically than shorter ones i.e. private financing becomes more favorable with a lower returns. Because longer terms have more time to grow, a lower return will affect them more; it will also increase the monthly amount you will need save up for the tax bomb.
Let's say you instead choose put the excess money in a good 1% savings account.
| Total Payments (Until Payoff or Forgiveness) | Remaining Balance
(When Loans Are Forgiven) | Taxes Due (from user input) | Total Cost of Loan Payback | Cost of Loan Payback in 2020 Dollars, aka Net Present Value | Year of Total Repayment or Forgiveness | Monthly Payment | Monthly Tax Penalty Account Savings in Mutual Funds |
REPAYE | $572,300 | $435,120 | $174,048 | $746,348 | $640,031 | 2045 | $1,511-$2404 | $562 |
PAYE | $435,606 | $534,650 | $213,860 | $649,466 | $569,792 | 2040 | $1,511-$2183 | $886 |
IBR | $435,606 | $534,650 | $213,860 | $649,466 | $569,792 | 2040 | $1,511-$2183 | $886 |
Private Refinancing (5 Year Term) | $433,157 | N/A | N/A | $433,157 | $424,664 | 2025 | $7,219 | N/A |
Private Refinancing (7 Year Term) | $456,925 | N/A | N/A | $456,925 | $443,575 | 2027 | $5,440 | N/A |
Private Refinancing (10 Year Term) | $503,112 | N/A | N/A | $503,112 | $481,278 | 2030 | $4,193 | N/A |
Now the cost of the our previous picks, PAYE and IBR, skyrockets past private options. Monthly payments stay the same (since they're based off income), but the amount you need to set aside increases. However, 1% is very, very bare-bones measure and creates a worst-case scenario. There are plenty of safe investment vehicles that generate more. We previously used a conservative 5%; the average 60/40 portfolio averaged about 8% over the last century. You can find savings accounts and CDs with 1.5%-2%. The break even point is around 2.25% which is realistically attainable.
*Investment returns fluctuate, but over the course of many years (10+), we can expect the return to be close to average.
*There are lots of good financial vehicles out there that are accessible to the average Joe/Jane. I recommend reading Burton Malkiel's A Random Walk Down Wall Street.
*VERY, VERY IMPORTANT: We use financial return as the measure of opportunity costs, but I want to stress that opportunity costs also include the utility we get from non-financial things. A house (which happens to produce financial returns too) generates utility: pride in having your own place, somewhere you can raise your family long term, etc. Likewise, a new car adds enjoyment, vacations add leisure and stress relief, and a college fund helps your children. All of these things generate
very real returns of investment, even if we cannot assign them concrete values. And these intangibles have different value for different people i.e. house might generate 1%, 5%, or 20% for you. In this sense, even if you choose a higher cost plan, you may actually be coming out on top in your own way.
Again, even if we assume a low investment rate and higher total cost, IDR plans give you the option of making larger payments whenever you can afford. Federal plans, however, allow you additional flexibility. Deferment and forbearance are more forgiving if you hit hard times and can't make payments. If you go into these, the payments you make towards loan forgiveness are pause, not reset. And if your situation ever changes (see factors below), you can refinance any time it becomes advantageous for you.
Regardless of which plan you choose, you should be re-evaluating your situation at least every year.
Factors:
-Salary increases will increase your taxable income. Taxable income increases your monthly payment, increases total payments, and decreases tax forgiveness. The more your salary increases, the more private refinancing becomes favorable.
-Getting married will potentially increase your taxable income (see above). However, you will also gain more tax benefits that can decrease taxable income. The cumulative effect will depend on how much your partner makes and whether you file together or separately.
-Having kids will add tax benefits and decrease your taxable income.
-The larger your debt after school, the more favorable IDR becomes. Monthly payments will remain the same, but you will need to save a little more each money for a larger tax bomb.
As a residency- Part 2: *best practice*
Federal plans can offer lower total costs through loan forgiveness as well as plenty of flexibility with repayment, but they gain more interest during residency when our ability to pay is at its lowest. We want to make payments in order to fight back some of the interest before it capitalizes, but if we refinance right away for a lower interest rate, but then we lose out on flexibility and loan forgiveness.
The solution is REPAYE, one of the federal repayment plans. REPAYE may or may not be the best long-term strategy, but during residency it is the best option because it offers a low monthly payment plus an interest subsidy. Since your payment will be based off our resident income, its pretty low: $304 to $345 a month for our average resident. Under the subsidy, if your monthly loan payments do not cover all of the interest charge, Uncle Sam will pay 50% of the difference. With $350,000 in loans and average 6.579% interest, we would be charged $23,026.5 in interest per year or $1,918.88 per month. Since interest charge is larger than our monthly payment, the interest subsidy will be half of the difference: $807.44/month in our 1st year. Under REPAYE, instead of only paying off $3,648, we've paid off $13,337.28. Any amount you can afford to pay after that just adds on top. Talk about bang for your buck. Over 3 years, we will have paid off more that $40,000 just making minimum monthly payments.
REPAYE gives us all the flexibility of federal loans. As you finish residency, you have lots of options. If federal repayment after residency is the best option, you can stick to REPAYE or switch to PAYE or IBR. If private refinancing is better, you can do that too. But wait, there's more! If you stick to any of the federal IDR plans, all of the payments you make during residency count towards loan forgiveness. So 17 years instead of 20 years. Thank you, Uncle Sam.
Now before we start putting everything we can into repayment during residency, there are a couple of things that take precedence. Establishing an emergency fund and retirement fund come first. Having cash on hand is always a good idea. The general rule of thumb is 3 to 6 months of living expenses in a savings account. Then make your minimum payment. You should also take advantage of all of the 401k matching your employer offers. Setting up retirement funds early is imperative, and employer matching is free money that will go a
very long way in the future. Anything after that can go towards additional loan payments.
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As usual, living modestly during school is the best way to reduce debt. Stay disciplined during residency and make payments where you can. Med school debt can be very intimidating for us big debters, but federal plans will make them very manageable over time. Even for FM doctors with big debt, there's hope. If you choose a higher cost plan, you are still gaining real value in having more money in the present. There's no need to live like a hobo.
Thanks for reading. Whew.
Resources:
Federal repayment calculator
Student loan calculator <- It's a pretty useful tool. It doesn't include new IBR but if you check the federal loan simulator, IBR is generally the same as PAYE. Lots of good articles on their site too.
Disclaimers:
I have no affiliation with Student Loan Planner. Run the numbers yourself to see what works best for you; you may have unique circumstances. Hiring a planner may be a good idea.