[Editor's Note: This guest post was submitted by first-year resident and regular reader Wynton Overcast. Many of you have had the same question and now thanks to the persistence of Wynton, no longer have to guess at the outcome of prepaying your loan under RePAYE. It turns out the answer is not what I expected or hoped. Wynton and I have no financial relationship.]
An Unanswered Question: Can I Keep the RePAYE Interest Subsidy if I Prepay My Loan?
After hunting around the internet, WCI forum, Reddit and previous WCI posts, I finally reached out to Dr. Dahle and the WCI Team with an unanswered question: Can I pre-pay my student loans while still trying to take advantage of the RePAYE 50% Interest Subsidy? Always the teacher, Dr. Dahle gave me the answer to the best of his knowledge but then advised me to test it out myself and “send me a guest post about it!”
Setting the Stage
Let’s set the stage a little bit. I am a first year resident with ~$150k of student loans at an interest rate of 5.5% and my loan provider is FedLoan Servicing. I entered the RePAYE plan this summer and thanks to my student status and my wife's relatively lower income last year, our expected payments for the next year under this plan are $0….which means that I will be getting the full 50% interest subsidy from the government and an effective interest rate of 2.75%.
(Important Note: we will NOT be going for PSLF in the future, so we are going to have to get rid of this debt at some point on our own. If you are going for PSLF it makes sense to make as many small payments as possible for the 120 required payments and you shouldn't even think about prepayments.)
So why even fuss about making early payments to the loan with such a low effective interest rate? Neither my wife nor I have 401k/403b matching available this year and we are not doing an HSA with my intern year benefits as we will be moving to my categorical program next. We are likely going to be able to max out both of our Roth IRAs this year and expect to have money to invest beyond this. So where should we pour our money next? It seems our decision is between 401k/403b contributions without matching vs starting to pay off the loan. Perhaps I should just proceed with 401k contributions and not worry about prepaying my loan. But there are a few reasons I would want to prepay my loan rather than do 401k contributions (family gifts earmarked for education, beliefs about market returns over the next 5-10 years). Regardless, this discussion is more about CAN I prepay and keep the subsidy rather than SHOULD I prepay. So let’s begin the joyful journey of communicating with a loan servicing provider.
Communicating With FedLoan Servicing
I tried to get a clear answer from FedLoan Servicing via a couple phone calls and emails without much success (actually had to teach a couple of the help center employees about how the 50% subsidy for unsubsidized loans was different than the 3 year deal for subsidized loans). One of the more clear email exchanges I had is below:
“Is the government interest subsidy that I will receive based on my expected/calculated monthly payments (currently $0) or based on the amount that I actually choose to pay per month (possibly paying more than my $0 requirement)?”
Their response was:
“The interest subsidy for the Revised Pay As You Earn (REPAYE) plan only applies to unpaid interest. If you make any payment to the interest it will reduce the contribution made by the government.”
More Answers From FedLoan Servicing
- The interest subsidy occurs the first day of each month and is automatically deducted from my growing interest. There is no documentation on my online account of this deduction but I can request documentation of the deduction and receive paperwork in 10-20 business days.
- Any payments I make early will go towards the growing interest. So when I make a payment in a given month, that payment reduces or completely eliminates the interest that would be targeted by the subsidy that month. Meaning, I would not see any (or would see a reduced) interest subsidy on the first day of the following month.
- She did not have any official FedLoan Servicing document with this information or an explanation of their policy.
My Prepayment Test
Now all this information did not line up with what others on the WCI Forum seemed to believe about prepaying loans under RePAYE. So, I put prepaying to the test:
- Current Principal: $149,734
- Interest at Beginning of Test: $1,864
- Daily Interest Accrual at 5.5%: $22.56
- Monthly Interest Accrual at 5.5%: $676.88 (30 days)
- Monthly Interest Accrual at 2.75%: $338.44 (30 days)
Based on my daily interest accrual and the information provided by the FedLoan Servicing employee, I paid $30 (to guarantee I was above the interest accrual on any given day) at three different points in the monthly loan cycle.
I paid $30 on a random day to see if the whole $30 would go towards the principal, if $22 would go towards the interest from that day and $8 would go to the principal, or if all $30 would go toward the interest.
It all went toward the interest.
I paid $30 on the day that the interest subsidy was awarded, the first day of the month. The logic here was if FedLoan Servicing was applying the interest subsidy the first of every month, then perhaps my account would be at $0 of interest accrued that month and all of my payment would go towards the principal.
It all went towards the interest
I paid $30 on the day immediately after my actual scheduled payment due date. Remember that my required monthly payments each month are $0, so my thought process was that perhaps FedLoan Servicing would process my $0 payment and that would be the date when the monthly accrual of interest reset to $0 allowing me to pay off the principal.
It all went towards the interest.
So How Did These Prepayments Affect My 50% Interest Subsidy?
Well on Day 1 of this experiment I had $149,734 of Principal and $1,864 of interest. On Day 20 I had $149,734 of Principal and $1,763 in interest. So essentially a net negative of $101 in interest. Huh? How did that happen? I paid $90, all towards the interest and I would have expected $428.64 of interest to accrue at the 5.5% rate or $214.32 at the 2.75% rate. Meaning, the best I would have hoped for was a net positive of $124.32 in my interest ($214.32 at the 2.75% rate minus the $90 I paid).
When I broke things down day by day I found that the $428.64 dollars of interest at the 5.5% accrued as expected and my three $30 payments posted within a couple days of when scheduled (interest net positive $338.64). The confusion came about because I appeared to receive a full month of the subsidy deduction on the first day of October for $338 (interest net $0) but then also received a subsidy deduction 11 days later for $101.56 (the equivalent of 9 days of 50% interest), suggesting that two of my three days of $30 payments took away two of my days of the 50% interest subsidy. Which leaves me to assume that the third day of $30 payments will be taken away from my next lump of 50% interest subsidy. (FedLoan Servicing does not provide documentation of when the subsidy payments or interest accruals are credited to the account. I was only able to sort this out because I took pictures of my account details on different days through this process).
Don't Overpay Loans Under RePAYE
So why all this work? Now I know that if I overpay my loans under RePAYE:
1) The overpayment will go towards interest and not towards the principal.
2) Any extra payments will take away my subsidy benefit in some capacity based on that payment.
Through this process, I also learned that there does not appear to be a way to direct any payment specifically towards the principal when paying ahead or over your minimum balance. Such payment will go directly toward the interest accrued.
Hopefully, this saves someone the time and hassle of having to communicate with FedLoan Servicing on their own time and clarifies what happens when overpaying/prepaying in the RePAYE program.
[Editor's Note: Thanks to Wynton for running an experiment that I was not capable of running on my own. I think it sucks that this is the way it works, but at least now we all know. So what should you do if you want to maximize the benefit of REPAYE but still pay down your loans because you're not going f0r PSLF? Just like for those going for PSLF, the answer comes down to a “side fund.” Simply make the extra principal payments into an investing account rather than sending them to the lender. You can invest it conservatively (You'll only make 2-2.5% right now in a high yield savings or money market fund but when you count the value of the REPAYE subsidy you're still coming out ahead) or aggressively, depending on how much risk you want to take with this loan pay-off money. Honestly what I'd probably do is just put it into retirement accounts, invest it aggressively, and then pay off the loan my first year or two as an attending. Of course, it is always worth running the numbers to see if the rate you can refinance to is less than your effective rate after the REPAYE subsidy. If you're not going for PSLF and the refinanced rate is lower, just refinance that sucker. Remember that right now the only two lenders on this list refinancing residents without an attending contract are SoFi and Laurel Road.]
What do you think? Do you think it's fair that those doing the right thing get penalized in this way? What are the consequences of incentivizing people to not pay off their federal loans? Have you made this mistake? Comment below!