The new Pay As You Earn plan is likely to have an impact on your child’s financial future that goes way past its original intent.
At the core of the new plan is lowering monthly payments on student loans and promising debt forgiveness for many borrowers.
One of the larger problems with Pay As You Earn is it encourages a person to stay in debt for 20+ years. Very low monthly payments, and the promise of debt forgiveness after 20 years, will keep more young people in debt for a long, long time.
It will have another negative consequence that nobody has talked about in the media yet.
It will create a dependency on the government that you need to carefully consider as a parent.
I’m not referring to the broader subject of government dependency and the size of government. I’ll leave that to the Democrats and Republicans to hash out. My concern here is not big-picture politics.
I’m referring to a very specific financial dependency that your child will experience if they decide to enter the Pay As You Earn plan for repaying their federal student loans.
Here’s how it will unfold.
- Most people choosing PAYE will be doing it for both the low monthly payment and the promise of debt forgiveness after 20 years. They will have friends and classmates who have learned how the plan works and who realize that they will not necessarily have to pay back all the money they borrow. They will end up comparing how much forgiveness they each expect.
- Pay As You Earn will be marketed by the government and colleges with these buzzwords made very prominent “forgive your student loans”. The promise of having your student loans forgiven will create some interesting conversations – and incentives. The person that might have paid their loans off aggressively after school might think “Well, why should I sacrifice my lifestyle after school to pay these loans off fast and get them out of my life? What if I am throwing away the chance to have my debt forgiven? Maybe I should get in the program and start living my life the way I want to (the pay all my friends are) and see if some of my student loans will be forgiven later on.”
- Pay As You Earn creates very small monthly payments. In many cases, the monthly payment is not even enough to cover the interest that is due for the month. That’s what called a negative amortization loan. Since the interest is not being paid in full, the combined amount due on the debt is actually going up every month, not going down. As the balance goes up each year, it will become even more important that the promised debt forgiveness happen. Your child will become more and more dependent on the government taking action as they watch their debt get bigger and bigger as each year goes by.
Once your child has committed to the smaller payments, and they have watched their balance grow every month/year, the more they need the government to come through on their promise of forgiveness. So they have to pay very close attention to the rules the government has set and hope and pray that no mistakes are made along the 20 year path to forgiveness.
Pay As You Earn says if you make all your monthly payments over a 20 year period they will forgive any balance. That’s 240 consecutive monthly payments. What happens if you miss a payment in month 71? What if you make every payment on time but there is a clerical error on their end and their system shows you did not meet all the rules? (You would be surprised how disorganized the student loan servicing side of the business is.)
There are many other rules as well. You must provide them your income tax return each year so they can see your income and set your monthly payment each year. (Just to mention one.)
Philip Lehman IV wrote in The Washington post in December 2012 about an experience he had recently in the Income-Based Repayment (IBR) program. PAYE and IBR are basically the same program. PAYE just accelerated certain provisions.
He is a doctor who racked up some large student loans in medical school. Here is a quote about his experience with one of the IBR/PAYE requirements.
“So it was when, on Aug. 16, I received a letter from Direct Loans informing that it was time to recalculate my monthly payment amount under IBR. (Direct Loans is a loan servicer, authorized through the U.S. Department of Education.) The letter notified, “If proof of your current income is not received within 90 days of the date of this letter, your repayment plan will be changed to Standard Repayment Plan, which could increase your monthly payment amount.”
On Oct. 23, I faxed last year’s tax return as proof of income and forgot about the process, until I received notice eight days later that my next month’s payment had skyrocketed 1,600 percent, from $177 to $2,916. This charge equals one standard repayment, and was only $125 less than my monthly take-home salary.
Shocked at this logarithmic rise, I called Direct Loans to ask for an explanation. The customer-service representative stated that the loan servicer had not received my forms in time and thus had to adjust my payment to the Standard Repayment rate. When I pointed out that we were having our conversation on Nov. 7, clearly within the 90-day window of the initial letter, the representative did not budge.”
What the customer-service representative was saying is he just got kicked out of the program. The promise of loan forgiveness is gone. The low monthly payments are gone.
That’s what she was saying.
Maybe he eventually got the problem fixed. But your child (and maybe you) will always be on the edge of a bureaucratic mistake like that. Your child will have large sums of debt hanging on the hope that the loan servicers and the federal government will get everything right over a 20 year period.
What if the Laws Change?
Do you think the rules and the laws around student loans are going to change over the next 20 years? Of course they will. That’s pretty much assured no matter which party is in the majority.
20 years is 10 lifetimes away for a politician. They have a hard time making decisions that have an impact six months from now. Who knows how the rules and laws will change over 20 years.
Your child would be sitting there at the mercy of politicians for 20 years wondering whether the promise of forgiveness will actually come true. I can’t think of too many things I would rather avoid than putting myself in that position. To me that is the opposite of freedom. That sounds like financial dependency well into a person’s 30s and 40’s (and maybe longer).
Are you going to encourage your child to get into the Pay As You Earn Program?
I’m not against accepting the benefits the government offers on college costs. By itself, the promise of debt forgiveness is not a huge problem in my mind. The problem is the price your child will have to pay to try to get the forgiveness. It requires staying in debt for 20 years or more on the hope that the forgiveness actually happens.
Think about this. What if your child had a group of friends and as each month or year went by they would all share with each other what their student debt balance was? Would she feel proud to show everyone her balance continuing to go up?
Or would she feel better if she could show her balance going down quickly because she was making larger monthly payments? Imagine her pride if she paid the debt off quickly.
I think this is an interesting scenario for a parent and child to consider as you evaluate whether to get into Pay As You Earn and sign up for 20+ years of debt to the government on the hope (which will turn into prayers as the years go by) of forgiveness.
The Path to Financial Freedom
The wise choice to seriously consider is to sacrifice after graduation and take the higher income and devote it all to paying the debt down within a few years. Get it out of your life quickly. Encourage your child to get that debt out of their life as fast as possible after finishing college.
That way they have their new income to put toward raising their family and saving for their children’s college education.
That’s the path to financial freedom. That’s the path away from dependency and weakness.