Finance expert Monica Mehta offers advice to entrepreneurs tackling real-world personal finance issues. Ask her a question and your query might be the inspiration for a future column.
Q: I want to quit my job to pursue a startup, but have $35,000 of student loan debt. Is there a way to shrink my loan payments while we are trying to get off the ground?-- Eric Lee, Austin, Texas
Today student loans represent the single largest debt burden for people under 40. In fact, from 2004 to 2009, only 37 percent of federal borrowers managed to make timely payments without postponing or becoming delinquent. Those most likely to default are unemployed or underemployed. Startup life, where income is anything but certain, qualifies you for the high risk camp, so it's important to know your options.
There are a handful of alternatives to help you reduce your debt burden in the short term. The first step is to identify whether your student loans are federal, private or a combination of the two.
Federal loans can be consolidated to reduce monthly payments. While you won't be able to lower your rate, extending your term from 10 to 25 years will reduce the amount you owe each month by 40 percent, from $402 to $267 per month. Selecting a graduated pay option can further minimize upfront payments. Borrowers start with a reduced monthly payment, which gradually increases after year two and four, settling into a higher standard monthly payment in year six for the duration of the loan.
Federal borrowers facing periods of low or no income can also file for Income Based Repayment (IBR) or Pay As You Earn (PAYE), which cap your monthly payments to a percentage of what you earn, not what you owe, according to Gary Carpenter, CPA and Executive Director of National College Advocacy Group, which supplies information regarding student loans. This means that if your income suddenly drops or stops altogether, you may have a zero monthly balance.
Monthly payments under IBR and PAYE repayment plans are capped at 15 or 10 percent of your discretionary income, based on federal guidelines. Borrowers must qualify and file an application annually with the Department of Education. And under new law, any balance remaining after 20 to 25 years of consistent payment will be forgiven.
As of 2012, only 700,000 borrowers were enrolled in IBR. The Obama Administration estimates that IBR could reduce payments for 1.6 million borrowers.
Options to defer private student loans are more limited. Few private lenders consolidate loans, and even those that do won't reduce your rate or extend repayment terms. Most will offer need-based forbearance, or a 12-month break from making payments. Some offer up to three 12-month grace periods to defer payments.
It's important to note that short-term debt relief is not without long-term pitfalls. Reducing your monthly payments does not make the debt go away. Simply stretching the term of a $35,000 federal loan from 10 to 25 years triples the interest due over the lifetime of the loan, from $13,000 to $39,000. And when the amount you pay each month doesn't cover interest, negative amortization can cause your loan balance to grow exponentially.
Taking the easy road today may set you up for a tough climb later. "Young people often focus on today's cash flow, ignoring they have the work of their life ahead of them," says Eleanor Blayney consumer advocate for the CFP Board, a non-profit that qualifies investment professional to become certified financial planners. "Electing for a long repayment cycle can set you up for debt drag that eclipses other important milestones in life such as buying a home, preparing for retirement and saving for marriage and children."
As an alternative to dragging out your loans, consider crafting a pre-emptive savings strategy to help you stay current while income is influx. In Eric's case, that means you'd aim to save two years worth of payments or $10,000 for an outstanding balance of $35,000. To build your nest egg, consider working in your present job a little longer or take on a consulting gig to throw off extra income.
Budget six to eight months to earn more and make lifestyle sacrifices such as taking on a roommate, cutting down meals out and extraneous expenses to help you save. An easy to use monthly payment calculator can help you determine your budget.
Despite the inability to shake student loan debt, more than 14 percent of borrowers have loans that are overdue. "If down the road you get into trouble, don't ignore your student loans. They can't be discharged in bankruptcy. They will be around no matter what," says Carpenter. "Contact your lender to create an alternative payment plan They don't want to see your loan go into collection either."
The bottom line is that getting a pass today means you're electing to double-down on your future success. Adding $26,000 to your interest burden won't seem like a lot if your business is successful but there's no escaping the fact that you are digging the hole deeper and reducing your financial flexibility. The preferred solution would be to find a way to save as much money as you can during the startup phase and leave the structure of your debt unchanged. Think about how you can really rein in personal expenses in the near term. You'll be better positioned to pursue the startup route and will maintain some of your financial freedom.
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