The primary value in the new Pay As You Earn program is it provides a safety net for the person that takes out student loans to go to college but has a low income once they graduate (or a low income because they didn’t graduate and get a degree).
The program sets a borrower’s monthly payment very low so it is a small portion of their income. And it promises debt forgiveness after 20 years. It helps prevent someone with a low income from defaulting on their student loans and getting into a horrible financial mess that could last their entire lifetime.
But one of the many negative (and perverse) impacts the program will have is this: it will cause a parent to question why they should use their savings to pay for their child’s college. By saving money and paying their child’s college, they may be passing up the debt forgiveness being offered in the new Pay As You Earn program.
As Jason Delisle of the New America Foundation said recently in a blog post at ED Money Watch, the program is “a large-scale tuition assistance program masquerading as a safety net”.
Let’s look at a quick example.
You are a parent and you have saved $50,000 for your daughter’s education. You have done your homework about the cost of college and how the new Pay As You Earn repayment program works. Your daughter will be getting some small scholarships and you are confident the $50,000 you have saved would pay the remaining costs.
Your daughter is a great kid. School was never her primary strength but she wants to go to college. She isn’t sure exactly what she wants to do after college but she believes it is smart to get a college degree. She has always loved kids though and thinks she may want to teach.
One of her dreams since she was a little girl was to be a Mom and stay at home with her children. She lights up just talking about it.
You have always been wise with your finances. That’s what helped you save the $50,000 for her education. It wasn’t easy to save that much money. But you sacrificed over the years because you felt strongly about paying for your daughter to go to college.
But, as your research has shown, this new Pay As You Earn plan for repaying student loans has a safety net built in for those who don’t end up making much money after college. And it provides for debt forgiveness. “What if my daughter teaches for a few years, gets married, has children and quits work to realize her dream? Would the government basically pay for some of her college through the debt forgiveness provision of Pay As You Earn?”
Then you say to yourself: “I’m not sure I like the idea of her being in debt to the government but let me take a quick look at how it might play out financially.”
Let’s say she borrows the $50,000 from the government that you would have used to pay for her college (including some graduate studies). You will let her know the money you have saved is there to pay any monthly payments that are required on her federal student loans. In the meantime, you will invest the money you have saved so it can grow.
Let’s assume she graduates and gets a job making $35,000 a year. Her student loans total $50,000. She works for three years then gets married and begins having children. She quits her job five years after graduation to live her dream of being a stay-at-home Mom.
In that scenario, how much of the student loans would she have to pay back? And how much debt would be forgiven by the government?
With the help of the New America Foundation’s calculator, it looks like she would make total payments of just under $9,000 over 20 years and have debt forgiveness of about $110,000. The debt forgiveness is the unpaid principal from the original loan plus all the interest that has accrued. When she quit work (she was filing her tax returns as married filing separately) the Pay As You Earn program set her monthly payment to zero.
In that scenario, you would have given you daughter the $9,000 to make her monthly payments for the five years she was working. The $50,000 you had saved, less the $9,000 you gave to her to make the payments, grew over the 20 years so that now you have about $60,000 in savings (or more).
The government only required your daughter (and you) to pay $9,000 for her education rather than the $50,000 you would have spent. And your money grew while the 20 years went by.
That would definitely support Jason Delisle’s comment that the new program is “a large-scale tuition assistance program masquerading as a safety net”.
You now have $60,000 of cash you could give to your daughter or use for your retirement. Wow!
Even if 20 years from now student debt forgiveness is still taxable (which I doubt) you would still be way ahead of the game by using the government’s student loans and the Pay As You earn repayment plan than to have used your college savings.
I Would Not Do That
Just to be clear, I am not in any way recommending this approach. I am just saying that this thought process will go on as more parents and students learn about the new Pay As You Earn program.
It will be especially tempting for those parents whose child may not be ideally suited to college. The safety net and forgiveness features of the new program make the economics compelling. I personally would not do it. But many people will (or at least many will give it some serious thought).
The ultimate question is would you encourage your child to take out student loans then stay in debt to the government for 20 years? I would not. That sounds horrible to me. That sounds like the opposite of freedom to me.
Hey, I write the Freedom From Student Loans blog! You won’t catch me putting my kids deep into student debt.