Payback time

Optometric Management, Mar 2000 by McClure, Lawrence H

You've borrowed and borrowed again to pay for your education. Here's how to keep debt from stifling your career.

About 85% of all students take out loans to help pay the costs of attending optometry school. Unfortunately, when they graduate, many of them experience a rude awakening. During their exit interviews, they receive information and paperwork relating to all of the educational loans they've taken. For many of them, this is the first time they get a real sense of just how much they`ve borrowed - and how much they're obligated to repay.

When confronted with these debts, an increasing number of graduates are opting to lower their monthly loan payments by consolidating their student loans through the Federal Loan Consolidation program. That's a good start, but consolidation alone actually increases debt burden in the long run.

This article will explain why that's true and how you should avoid that extra burden by employing an additional financial tool: prepayment of principal. The combination of consolidation and prepayment of principal will save you a substantial amount of money. Let's look first at how consolidation works.

The good and bad news about consolidation

The Federal Loan Consolidation program provides borrowers with the opportunity to refinance several outstanding loans into a single larger loan. The following loan programs can be refinanced into a consolidation loan:

Average Debt for Optometry School Graduates

The latest figures available from the Association of Schools and Colleges of Optometry show that in 1990, the average education debt of an optometry student at graduation (including undergraduate debt) was $49,703. In 1996, the average debt rose to $81,627, a 64% increase. Indebtedness continues to increase.

Federal Subsidized Stafford Loans

Federal Unsubsidized Stafford Loans

Federal Perkins Loans

Health Professions Student Loans (HPSL)

Nursing Student Loans (NSL)

Loans for Disadvantaged Students (LDS)

Health Education Assistance Loans (HEAL) prior Federal Consolidation Loans.

Consolidation simplifies life. Instead of having to manage several monthly payments to different lenders and loan servicers, you end up with only one payment to one organization. Plus, you spread your payments over a longer period of time (up to 30 years), which lowers the amount you owe each month. Lower monthly payments are an especially important consideration at the beginning of your career when income tends to be low.

That flexibility also frees funds for other uses, such as savings and investments. But beware: There's a substantial price to pay for this convenience. Because the payback period is extended, you pay interest for a much longer period of time. And, as you'll see below, that extra interest can really add up.

Why you must prepay principal

Consider three different repayment schedules for a $100,000 loan with an 8% interest rate: the standard 10-year (120-month) repayment period; a 20-year (240 month) repayment period; and a 30-year (360 month) repayment period - the maximum time period available within the Federal Consolidation Loan program:

Number of payments / 120 / 240 / 360

Monthly payment / $1,213 / $836 / $733

As you can see, lower monthly payments and longer periods of repayment result in significantly larger amounts of interest. That's where prepaying of principal comes in. It worK's because most loans (including all federal student loan programs) only charge interest on outstanding principal. Once you repay a dollar of principal, you're never charged interest on it again.

A sample amortization schedule-a breakdown of monthly payments - makes this more clear. (See "Figure 1: Understanding an Amortization Schedule," previous page.)

How it's done

One of several ways to prepay principal is half-time payment, which, as the name suggests, cuts your repayment period in half and saves you a bundle.

Suppose your student loan payments are too high, so you decide to reduce your monthly payments by consolidating your loans and extending the repayment period from 10 to 20 years. As I said earlier, that's a good start; on a $100,000 loan you'll lower your payments by approximately $375 per month.

However, if you only make the minimum payments for the entire 20-year repayment period, you'll pay an additional $55,151 in finance charges. That's over and above the $45,593 you would have paid if you'd kept the 10-year repayment period.

Instead, don't make just the minimum monthly payment. Each month, in addition to the minimum payment, prepay the "principal due" portion of the next monthly payment. In effect, you're making two payments at once - you're just not paying the interest on the second, or extra, payment.

The following month, do the same thing, starting with the next "official" payment on the list. By doing this every month, you'll pay off the principal twice as fast and eliminate half of the interest payments.

Let's work through an example, using "Figure 2: How to Use a Half-Time Payment Plan," above. For your first payment, you'd write out two checks to the lender. The first, which is marked #1a in Figure 2, is for the official payment amount - $836.44. Then you'd write a second check for the amount of principal due for the following payment-$170.94 (marked #1b in Figure 2).