Minimizing the Repayment Cost of Federal Student Loans

TL;DR

This paper analyzes optimal repayment strategies for federal student loans considering their unique features, revealing that strategies vary with loan size and that income-driven schemes mainly benefit large-balance borrowers.

Contribution

It provides a novel analysis of how loan size influences optimal repayment strategies, highlighting the roles of income-driven schemes and interest features.

Findings

Maximum payments are optimal for small loans.

Minimum payments are best for very large loans.

Intermediate loans benefit from initial minimum payments.

Abstract

Federal student loans are fixed-rate debt contracts with three main special features: (i) borrowers can use income-driven schemes to make payments proportional to their income above subsistence, (ii) after several years of good standing, the remaining balance is forgiven but taxed as ordinary income, and (iii) accrued interest is simple, i.e., not capitalized. For a very small loan, the cost-minimizing repayment strategy dictates maximum payments until full repayment, forgoing both income-driven schemes and forgiveness. For a very large loan, the minimal payments allowed by income-driven schemes are optimal. For intermediate balances, the optimal repayment strategy may entail an initial period of minimum payments to exploit the non-capitalization of accrued interest, but when the principal is being reimbursed maximal payments always precede minimum payments. Income-driven schemes and simple accrued interest mostly benefit borrowers with very large balances.