Forbearance during residency is a terrible financial decision. Yet 25-50% of residents and fellows are opting for this route. Maybe they don’t realize the negative impacts – they don’t see the tens of thousands of wasted dollars. Maybe it’s just the easiest route available (in the short run). Maybe all of the choices with student loans cause analysis paralysis and people just opt for no payments under forbearance until they can figure it out. Or maybe they are worried about making ends meet and can’t commit to a student loan payment.
Whatever the cause, this post will shed some light on the dollars and cents of the forbearance decision. That way, at minimum, you can understand how impactful this decision really is.
1) Wasted PSLF Qualifying Payments
This missed opportunity might cost the typical resident up to several thousands of dollars per month if PSLF comes into play. In the PSLF world, each income-driven payment – like PAYE payments or other PSLF eligible repayment plans – provide the same value as the 10 year standard payment, but at a substantial discount. This comes as a result of lower income typically associated with residency and fellowship (relative to future earning potential). It’s like making payments at a 90% discount. Missing even one of these qualified payments is a big deal! If you consider 3-5 years of forbearance, were talking up to six figures.
For example, let’s assume you’re married with one child and owe $300,000 at 6% interest. You’ll earn $50,000/yr during 4 years of residency. The PAYE (or RePAYE) payment would be $165/mo. If you will eventually qualify for PSLF, making the $165/mo payment provides the same net value as the $3,331/mo payment. Either way, you are making 1 payment toward satisfying your 120 payment obligation to eliminate the debt. Obviously if those were the only choices, you would opt for the $165/mo payment. But, forbearance is also a choice. With this option, you pay $0/mo and receive no credit toward PSLF or repayment. Let’s say you forbear for 12 payments and realize it’s a bad move. You make income-driven payments the remainder of residency. In practice your income bumps you up to 10 standard repayment. The net cost of this 12 month period is $37,992. You see this annual cost comparison illustrated below. The missed payments in year one cause the additional payments in year 11.
2) No Tax Deduction
Residency is likely the only period in your lifetime where you’ll be able to deduct student loan interest on your taxes. However, to receive this deduction you must actually make payments! Forbearance during residency equals no tax deduction. If you actually make payments during residency, the deduction (assuming you’re income is below the cap) reduces taxes and effectively lowers the NET cost of your loan repayment by up to 30%.
3) Interest Capitalization
If you aren’t going for PSLF, you might be thinking forbearance is not such a big deal. Not true! Forbearance causes your interest to capitalize each year. This basically means the interest gets added to your principal balance. When this happens, the amount you’re charged on interest becomes larger, which increases interest the following year. Capitalization causes you to pay interest on interest. Avoiding it allows you to pay interest ONLY on principal. When you make income-driven payments (like PAYE or IBR), you can avoid interest capitalization during residency. Although this isn’t a big deal if you’re going for PSLF, it’s a major concern for everyone else. Why? More interest equals more cost for you.
Let’s look at an example $300,000 federal student loan with a 6% interest rate and no payments being made. Below, you can see annual interest grows each year with the capitalizing loan (this is the effect of being charged interest on your interest). Annual interest stays level when capitalization is avoided. Capitalization allows interest to compound and grow much faster.
You can see the annual cost of capitalization and the cumulative effect of capitalization below using the same example.
This adds up over time and has the effect of costing you tens of thousands over the course of the normal residency or fellowship. It’s well worth it to make the minimum income-driven payments and avoid this.
To further clarify, let’s assume you have a similar situation as illustrated above and payment is $2,000/yr under PAYE during 5 years of residency.
First Option: Come up with the $2K/yr PAYE payments. At the end of 5 years, you owe $380,000 and have paid $10,000.
Second Option: Forbear all 5 years. At the end of 5 years, you owe $401,468 but haven’t paid anything.
It would be like someone guaranteeing to pay you $21,468 at the end of five years if you pay them $2,000/yr for five years. In case you’re curious, that’s a 27.40% rate of return. That’s a ridiculously good investment – a rare opportunity every smart investor would jump all over. Yet most residents are opting for forbearance!
4) Lost Subsidized Loan Benefits
As if it wasn’t bad enough already, there’s one more cost associated with forbearance. Many federal loans offer subsidized loan benefits – subsidized loans allow for the government to pick up a portion of the unpaid interest tab. With the most common subsidized loans, if you’re using income driven repayments, the government agrees to pay interest that is charged above your scheduled monthly payment for the first three years of residency. For example, if you have a subsidized loan of $40,000 at 6% interest and have $0/mo payment under RePAYE, the government picks up the $2,400/yr interest tab for three years (totaling $7,200). If you opt for forbearance, you effectively throw $7,200 out the window.
The more recent subsidized interest benefit provided with federal loans is the new RePAYE program. With RePAYE, the government picks up the tab on 50% of unpaid interest. The medical resident might have a loan that generates $18,000/yr of interest and have scheduled payments of $2,000/yr. Fifty percent of the $16,000/yr unpaid interest gets forgiven by the government IF you are using the RePAYE repayment plan. When you forbear on your loans, you miss out on all of this “free-money”.
5) No Payments = More Debt
Although this is the least impactful reason for the typical resident, it’s certainly worth considering. Paying debt requires some level of discipline, especially when the forbearance carrot exists. If you choose not to pay anything now, it will be harder to dig out later. If you don’t develop the discipline of making regular payments now, it will be harder in the future.
Your Repayment Plan
Any one of these reasons should be enough to show it’s a terrible idea to forbear. When you add them all together, it makes it one of the worst possible financial decisions you can make in residency. To put this into perspective, forbearing on six figures of federal student loans is much worse than taking out high interest rate credit card debt. Don’t get me wrong, racking up credit card during residency is pretty terrible, too, but forbearance is worse.
For some residents, this should be a simple fix. Come up with the couple hundred per month payment required under one of the income-driven repayment plans. It’s well worth it! Many are truly in a financial hardship and believe they just cannot come up with the payments. For starters, take a look at your estimated repayment under PAYE or if not eligible RePAYE. You might be surprised. The resident with a stay-at-home spouse and multiple children could end up with payments at $0/mo. Although the payment is $0, it still qualifies for an income-driven payment. Think outside of the box if necessary. Do what you must do to make the minimum payments.
In my informal surveys with resident clients and friends, I have found at least half of all medical residents are forbearing on their student loans. Do you think this is accurate? Why do you think so many residents are opting for forbearance? Do you think they realize how costly this is?