Pay As You Earn is Not What it Appears

There has been a lot of press recently about expanding the Pay As You Earn (PAYE) plan for paying back your student loans. Generally speaking, Pay as You Earn creates a payment of 10% of your income. And promises debt forgiveness after 20 years.

It’s important to keep your “common sense” hat on when looking at this program and deciding which repayment plan is in your best interest. You pay down debt by paying down the principal balance. The more you pay, the more the debt goes down.

The allure of PAYE is to reduce your monthly payment. The opposite of what it takes to drive your student loan balance down.

Here are some posts that will help you if you are considering one of the student loan repayment plans based on income.

The Pay As You Earn Plan Drives More People Deeper Into Student Debt

And this is part 2 in a series 11 downsides to be aware of.

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The Pay As You Earn Plan Drives More People Deeper Into Student Debt

The Pay As You Earn (PAYE) student loan repayment plan is driving more people deeper into debt. Its original intent was noble because it can provide a safety net for those with large student loans and who do not graduate or who do not make a lot of money after college.

The bad news is it promotes staying in debt for 20 (10 years in certain cases) years in the hope of some debt forgiveness (which would be taxed as income in many cases). It also makes the monthly payment very low in order to encourage the student to spend money on other stuff. To become a “consumer” and start spending their money.

It also promotes more students going deeper into debt.

The Wall Street Journal wrote an insightful article titled Federal Plans That Forgive Student Debt Skyrocket. Here is a quote from the article at yahoo finance:

“Law schools at Columbia University, the University of Chicago and Georgetown University are among those offering some graduates additional aid to cover all or part of their minimum monthly payments under the federal plans.

Max Norris, a 29-year-old lawyer for the state of California, illustrates the potential costs of the program. He pays about $420 a month to the Education Department on his $172,000 in debt, which he says fails even to cover the interest owed. But his out-of-pocket expense falls to $100 monthly after aid from his school, University of California’s Hastings College of Law.

Mr. Norris, who makes $60,000 a year in his job, would have about $225,000 in debt forgiven after 10 years, assuming he stays in public service and his salary rises 4% annually, according to a repayment calculator created by the New America Foundation, which advocates less-generous forgiveness.

He said he learned of the programs before enrolling. “My intent the whole time in going through law school was to take advantage of this program,” he said.

Schools aren’t shy in touting the programs’ benefits.

Georgetown said on its law-school website until recently the school’s aid combined with the federal plan “means public interest borrowers might not pay a single penny on their loans—ever!”

I wrote a number of posts about the downsides of PAYE to try to prove to you that it was something to stay away from unless you were nearing default on your student loans.

Read this real quick. It summarizes 11 downsides to be aware of.

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Your family legacy: Student loan debt or financial freedom?

One of the decisions you have to make when you have student loans is how to pay them off. Are you going to pay them off quickly after school? Or are you going to go for the lowest monthly payment you can get?

There are pluses and minuses to both approaches. But I would like you to take a big picture look at what the ramifications might be on the family legacy you pass down to your children.

The Future

Let’s play out an example where you are a parent. For this example, we’ll assume you were unable to save money for your child’s college because you were paying on your own student loans over the 20 years since you graduated from college.

Your 18 year old son is going to use student loans to attend school.

Everything works out good in school and he graduates, gets a good job, qualifies for the new Pay As You Earn plan and begins making his monthly payments on his student loans (meaning he is signing up to a 20+ year repayment plan with the possibility of debt forgiveness). Life rolls on and he falls in love, gets married to a wonderful woman, and has children. He continues making the monthly payments on his student loans as well as paying for all the other costs of raising a family.

At this point, he is in his early 30s and his children are between the ages of one and four. He has another fifteen or so years left on his student loans. That means he will still be making payments on his student loans even as your grandchildren reach their teenage years. (And that’s before considering how much student debt his family may be carrying now. It’s possible his wife brought student loans into their marriage as well. The majority of students come out of school with hefty student loans so most marriages include a combining of student loan debt.)

Monthly Payments Make Saving for College Difficult

With one or both of them still in debt on their student loans, together with the other costs of raising a family, having a couple cars, and buying a house, your son is unlikely to be in a position to save money for your grandchildren’s college education.

Chances are, when it’s time for your grandchildren to go to college, your son won’t have much money saved for his children’s college education. Which means your grandchildren will have to take out student loans so they can go to school – just like he did.

Your grandchildren will begin their young lives in student debt just about the time your son’s student debt is finally paid off.

Picture that in your mind for just a minute.

Your grandchildren are starting their young adult life out the very same way your son did – in debt.

Look What Just Happened

The student debt cycle has now been handed down to your son and to your grandkids. And they will probably hand it down to their kids as well. It’s very difficult to break the debt cycle once it becomes generational.

You don’t want to leave a legacy like that, do you?

Paying your student loans off quickly is the ticket to financial freedom – for you and your children.

Two young professionals on paying off student loans

I received some very insightful comments on my post about the wisdom of paying student loans off quickly.

I usually share these posts in several LinkedIn groups. One of the groups is made up of young professionals in Texas (where I live). That is where two of the comments came from that I would like to share with you.

They are sharing their experience and goals for the benefit of other young people in debt.

Here is the first comment from a young attorney.

“I made a goal to pay all my student loan debt off in 10 years… I know it hurts to pay that high student loan bill every month, but I took the approach of knocking out the highest interest rate loan first. I’m proud to say that next year it will be paid, and I will have an extra $450/month to throw at the rest of my loans and investments.

One last thought… If nothing else motivates you to be money savvy, when you pay your student loans off in 10 years, you save an insane amount of interest and free up a large amount of assets for investment and saving opportunities.”

The government’s new Pay As You Earn approach to repaying student loans encourages a borrower to pay over 20 years. She is pushing to get it paid off in 10 years. Of course, you could make a good case that 10 years is still a long time. But at least she is not falling for the unwise advice the government is handing out.

Here is another comment.

“I made the mistake of leaving the school that offered the best scholarship for one that left me with over $40K in student loan debt. That said, the past 7 years since graduating have been a nightmare; like you did, I’ve paid some, then not paid some, all depending on my financial situation at the time. I’m in my last year of graduate school (which I am paying out of pocket so as to not incur more debt) and am paying on my mom’s loan that she took out for my undergrad (it couldn’t be deferred b/c she is not the one in school).

Now, my new husband (who graduated loan-free thanks to a full athletic scholarship) and I are seriously considering our options to get my loans taken care of over the next year or two. We literally had that conversation this morning and are going to sit down and crunch numbers- I saw this article in my email and appreciate your insight. I keep thinking to myself, I know it’s not going to be easy but in the long run it’ll be worth it. Thanks for sharing!”

There are several important things we can all learn from her note to me.

The first is the financial aid offices and the government make student loans seem like they are like any other form of aid. But they are far from it. They try to entice you to say yes to a school even if it is not wise financially. Only later will you find out that debt is real… it has sharp teeth… and it bites!

The second message is she is getting focused on paying her student loans off quickly. That’s awesome. She and her husband are giving serious thought to sacrificing now in order to avoid having a big problem down the road.

That’s wise. Not easy, but wise.

What is Wise for You As An Individual

And the most interesting insight of all – paying the debt off quickly is the exact opposite of what the government’s new Pay As You Earn program encourages.

Hmmmmmmm. Maybe we have a rule of thumb here. If the government preaches the value (and necessity) of student loans and that they should be dragged out for 20+ years – maybe that is a good sign that it is unwise for you financially.

I am not anti-government. I just firmly believe that dragging around student loans is unwise financially. Sometimes it must be done. But it is not the goal you want if you are young and considering how best to deal with student loans as you come out of school.

Just a thought to consider! :-)

The new Pay As You Earn student loan repayment program – A blessing or a curse? Part 2

The new Pay As You Earn program will have a huge impact on your children if they borrow on student loans.

In part one of this series, I talked about the new Pay As You Earn (PAYE) program. The government made a big change late in 2012 that will make it easier for new borrowers to reduce their monthly student loan payments. That might sound good at first glance, but there are some nasty ramifications lurking beneath the surface.

And the government is offering a big carrot to go with that change – the promise of debt forgiveness after 20 years.

Uncle Sam says “Don’t worry if you have a bunch of student loan debt 20 years after you get out of school. We’ll have a nice little 20-year anniversary gift waiting for you. We’ll forgive the debt. A gift from Uncle Sam to you. And it’s all FREE. Just sign your name right here on the Master Promissory Note.”

Yes, but…

The primary value in the new repayment plan is it provides a safety net for a person trapped in student loans. The problem is the plan has downsides that will harm your child financially for years to come.

Here’s 11 downsides you need to understand before you and your child decide to get into this new program (or borrow on student loans at all).

  1. Puts more people into debt… increases the amount they borrow… and keeps them in debt longer (that’s not the path to financial freedom)
  2. Creates a family legacy of debt (hard to save for a kid’s college while staying in debt for 20+ years)
  3. Feeds the college cost explosion (college costs will go up even faster)
  4. Encourages “underwater basket weaving” degrees (a degree that does not pay well is not a problem unless you borrow money to do it)
  5. Promotes spending over saving (this is the path to the poor house)
  6. Adds to wealth inequality (going into debt and staying there for years and years creates people who are broke)
  7. Creates strange financial incentives (getting married encourages you to file separate returns or your spouse’s income will be considered in setting your monthly payment)
  8. Discourages parents from using money they have saved for college (why use saved money when the government will forgive the debt)
  9. Encourages reliance on the government (once your debt starts growing because of the low monthly payment, you become more and more dependent on the government’s promise of forgiveness)
  10. It may get in the way of marriage (it will create some interesting pre-engagement discussions about each person’s student debt)
  11. Results in more parents going into debt (as college costs rise, more parents will borrow money on top of their child’s student loans)

And there’s more…

I will continue this series in upcoming posts and we’ll look at some specific examples so you can see how this program will impact you and your children.

Stay tuned for Part 3 (and beyond) on this subject.

Then you can decide whether you should encourage your child to get into this new program.

Click here to see how Pay As You Earn provides forgiveness even if your household income over the 20 years of repayment was $5,000,000. Surprising the program is designed this way… but it is!

Student Loan Forgiveness Even if You Make $5,000,000

Do think a borrower could have a household income of $5,000,000, quit work to be a stay-at-home parent, receive a $500,000 inheritance, and still have all their student loans forgiven by the government?

It might sound strange and counterintuitive, but the answer is Yes.

The new Pay As You Earn plan from the federal government not only makes it possible, it makes it highly likely that this scenario will happen. This new approach to student loan repayment became effective December 21, 2012. And boy does it change the nature of student loans. As I’ll show you in this example, the new plan redefines student loans in a dramatic way.

Let me show you how Pay As You Earn works. This example shows how a person can borrow $50,000 on student loans from the federal government, have a household income over the 20 year repayment of over $5,000,000, and receive $89,000 of student loan forgiveness.

Let’s base our example on a “typical student” example at President Obama’s web site barackobama.com/education-calculator.

The graphic shows that the new Pay As You Earn plan makes it possible for your Child to go to college. It even “saves” her money along the way based on her monthly payment in year one. Of course, the plan requires payments over 20 years and promises forgiveness of any student loans that remain after that 20 year period.

So let’s fast forward her life and see how much debt might be forgiven. We’ll refer to her as Cindy. (I am using the fantastic calculator tool created by The New America Foundation to run the example. You can download the spreadsheet here.)

Cindy gets her undergraduate and graduate degrees and lands a job making $45,000 a year. Her student loans are $50,000. She qualifies for the Pay As You Earn program because she has a “partial financial hardship” (her monthly payment under Pay As You Earn is less than under the 10 year repayment plan).

She gets an apartment and starts her new life. She begins making her $235 monthly student loan payment and provides her tax return each year so her loan servicer can calculate what her monthly payment needs to be based on her income.

Over the first three years she gets a raise of 4% per year. Her monthly payment in year two goes up to $247. In year three the monthly payment goes up to $259.

Here are the numbers for the combined three year period after graduation:

Household income                          $140,472

Monthly payment                           $259

Total payments made                    $8,893

Student loan balance                     $51,419

Estimated debt forgiveness        $20,610

 

Love Comes Calling

Another thing happened during those first three years after graduation: Cindy started dating a great guy. They fell in love and at the end of her fifth year out of school they got married. He has a great income ($250,000 a year) so they decided to file their tax returns as married filing separately otherwise the Pay As You Earn plan would calculate her monthly payment using his income as well as hers (it would use their household income if they filed jointly). The rules of the plan allow this. They aren’t gaming the system. (Remember, this is the pay as “you” earn plan, not the pay as “your spouse” earns plan.)

Things continue to go well at her job and she continued to get the 4% pay increase each year. In year eight, they welcome their first child into the world. They have their second baby in year ten and Cindy and her husband make an exciting decision. Cindy has always wanted to be a stay-at-home mom. They decide now’s the time for her to quit working and stay home with their two toddlers.

Pay As You Earn will set her monthly payment to zero since she will not be earning any money. Their household income is more than enough for them to live well and raise their young family. The assumption is Cindy’s husband is able to increase his income at 4% a year (from the $250,000 he was making when they got married).

Here are the numbers for the combined ten year period after graduation:

Household income                          $1,830,306 (of which $476,226 is what Cindy made)

Monthly payment                           $0

Total payments made                    $29,499

Student loan balance                     $54,876

Estimated debt forgiveness        $89,251

Ten years into the student loan repayment and the loan balance has actually risen from when Cindy graduated. The total payments she has made of $29,449 have not paid all the interest that became due on the loans.

Over the next five years, Cindy continues to stay at home with the kids. It provides a quality of life that her family enjoys and values. Her husband continues to grow in his career and they solidify themselves in their community and their status in the middle class.

Here are the numbers for the combined fifteen year period after graduation:

Household income                          $3,477,753 (of which $476,226 is what Cindy made)

Monthly payment                           $0

Total payments made                    $29,499

Student loan balance                     $72,064

Estimated debt forgiveness        $89,251

Cindy’s monthly payment went to zero back in year 10 when she quit working. If you don’t “earn” the plan does not require you to “pay”. And since you can file married filing separately on your federal tax return, your household income is not considered. That’s how the plan works. She is not doing anything wrong as far as the Pay As You Earn plan is concerned.

Her student loan balance is going up every month because there are no payments being made. All the interest that will accrue on the loan will be part of the debt forgiveness.

Cindy and her husband have talked about whether it would be smart to just pay off the student loans. If they did, the original college cost of $50,000 would have cost them $101,563 (the $29,499 paid plus the balance owed of $72,064). And right now the Pay As You Earn plan will forgive the entire balance five years from now. They struggled with what to do. The balance has been going up for so long that it doesn’t make sense to pay it off now. And one of the purposes of the plan was to make forgiveness possible.  They decide to ride it out.

A $500,000 Inheritance

Cindy’s father passes away in year sixteen and leaves her an inheritance of $500,000. They put it in savings since they have already concluded that it doesn’t make financial sense to pay the debt off when it is about to be forgiven by the government. They have a net worth now of just under $2,000,000.

They continue to live their life and Cindy home schools the children. They hit the 20 year mark in the Pay As You Earn program.

Here are the numbers for the 20 years in the Pay As You Earn plan:

Household income                          $5,482,123 (of which $476,226 is what Cindy made)

Monthly payment                           $0

Total payments made                    $29,499

Student loan balance                     $0

Actual debt forgiveness                 $89,251

 

Is the New Pay As You Earn Plan Wise or Foolish?

People will have lots of reactions to this example.

Some will be shocked to learn the government will be forgiving student loans to rich people. Some will accuse people like Cindy and her husband of taking advantage of the system. Some will be pissed off that the government is putting the burden of student loans on taxpayers rather than the people who borrowed the money. Others will be excited to get into the Pay As You Earn plan.

The fascinating thing about this example is despite the appearance of helping those who do not need financial assistance; the government actually achieved the two primary objectives that led to the creation of this plan in the first place.

The first objective of the plan was to make it easier for a person to spend more of their income in the economy. This program was born during the time bailouts and stimulus money was being poured into the economy in a desperate attempt to boost economic growth and reduce unemployment. That’s why the monthly payment is set at 10% of discretionary income. It frees up cash for a person to spend more of their money to boost the economy.

The second objective was to make sure that money is not a barrier to your child going to college. The graphic on President Obama’s web site during his re-election campaign shows clearly that the government wants a parent and their child to say yes to college.

The repayment plan was created to serve those two objectives. Cindy and her husband were not gaming the system. They were just following the rules setup by the government to achieve its two objectives. She went to college and she paid a portion of her income to the government for 20 years. That’s exactly what the new plan calls for.

Pay As You Earn – The Name Says It All

The name of the plan does a great job describing how it works. It also provides a hint at where student loans are headed in the future. I’ll talk more about that in just a minute.

Let’s look at the key parts of the plan that make the forgiveness possible for Cindy.

  • You “pay” on your student loans “as you earn” money. You don’t pay based on how much money you borrowed (the way every other form of debt works). So if you don’t earn, you don’t pay. That’s why Cindy was able to quit work. Her monthly payments under the program went to zero. She could stay current on the debt even without working because the plan called for zero payments based on her zero income.

 

  • The plan is set up to look at the money “you” earn. Once you marry, the plan allows you to file as married filing separately. That way the government will only consider your income, not your spouse’s. It’s not the “pay as your spouse earns” plan. That’s why the $5,000,000 or so of income earned by Cindy’s husband after they married was not considered in setting her monthly payment.

 

  • The debt balance grew during the entire 20 year repayment period. That’s because her monthly payment while she was working was less than the interest that accrued on her debt balance. This is the part of Pay As You Earn that many people don’t see or understand. The super low monthly payment was using the Buzz Lightyear approach to loan amortization “to infinity… and beyond”. The unpaid interest each month causes the total debt to rise each month. As the balance grows, the borrower becomes more and more dependent on the promise of forgiveness. They are basically digging themselves a deeper and deeper hole based on the government “saving them money” with the super low monthly payment. It also steers a person away from paying off the debt early because their plan all along was to accept the gift of forgiveness the government promised.

It’s this last point that provides a glimpse into the future of student loans.

Think about this for a minute. If it doesn’t matter how much you borrow, your monthly payment is based solely on your income and not on your debt, and any remaining balance after 20 years is forgiven – why even call the loans debt? Why even call them loans? Why keep track of a “student loan” balance at all? It only serves to complicate the whole process when you think about it.

If the $50,000 the government paid for Cindy to go to college was never called a loan, nothing would be any different financially. There would just be no need to track the debt or label anything as “debt forgiveness”. It’s an unnecessary administrative burden based on how the plan works.

And it’s that point that makes it possible to look into the college attendance crystal ball. The next step after Pay As You Earn is an interesting one to consider.

I’ll share my view on the future of student loans in upcoming posts.

 

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Pay As You Earn will discourage parents from using their savings to pay for college

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?

WOW

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. :-)

Pay As You Earn can make your child dependent on the government

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.

I wrote about that here.

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.

  1. 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.
  2. 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.”
  3. 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.

 

Is a small student loan payment wise or foolish? Part 2

In my last post on the new Pay As You Earn (PAYE) program from the federal government, I asked the question “Is a low monthly payment on a student loan smart”?

I walked through an example that shows how the government (the primary student loan lender) is advertising low monthly payments as “saving you money”.

Now let’s look at the program from a little different perspective.

How About a 40-Year Amortization?

If your child came out of school with $25,000 in debt and an income of $35,000, their monthly payment under PAYE is $152. The calculator at barackobama.com/education-calculator says they save $1,628 a year with their low “Payment under Obama” as compared to the $288 per month payment under the standard 10-year payment plan.

So how many years did the government use in this example to get to the $152 monthly payment? The answer is 40 years! Ah, no wonder the monthly payment is less than a 10-year amortization.

How About an 89-Year Amortization?

Here’s another version of that example.

Let’s say your child had the same $25,000 of debt but their annual income (adjusted gross income) was $33,750. That would create a monthly payment of $142. So how many years would it take to pay off a $25,000 loan making a $142 per month payment?

The answer is 89 years. Holy cow! You would be on an 89 year amortization schedule. That’s three times as long as a 30 year mortgage.

Does that seem weird to you? Does that seem downright dumb (for both the lender and the borrower)?

And the government says you will be saving money by making this low monthly payment?

Now the rest of the story…

The government doesn’t really want you to take 89 years to pay them back (they know you’ll probably be dead by then). So they created a new wrinkle. The new Pay As You Earn program says that if you make all your monthly payments on time for 20 years (240 monthly payments without fail) they will forgive the balance at the end of the 20 years.

They know there is likely to be a balance at the end so they will just forgive it for you. The government will erase your debt.

No mention that they will also send you a 1099 since the amount forgiven is treated as taxable income. And the tax is due immediately – in full. Kind of like getting a beautifully wrapped Christmas present – only to find a financial bomb inside.

What’s Up?

The government wants more students going to school. Offering student loans with low monthly payments and the promise of debt forgiveness is the carrot they are using to get more people to say yes to college (no matter how much it costs).

They also want people to spend more of their money after they graduate on buying cars, buying houses, and participating fully as a consumer. That’s one reason they are providing the super low monthly payment.

They are also assuming that your income will go up over time and you will be able to pay more than when you first get out of school.

But encouraging a person to stay in debt for 20+ years is more likely to hurt them financially rather than help them become financially independent.

It teaches the opposite of don’t buy things you can’t afford. It teaches the opposite of get out of debt and save money.

So back to the question: Is a small student loan payment wise or foolish?

Send me an email and let me know what you think.

 

The new Pay As You Earn student loan repayment program – a blessing or a curse? Part 1

Big changes are on the way in how student loan repayment works. And they are going to make your job of parenting even harder (in a twisted sort of way).

If you’re a big believer in the value of debt, you’re going to love these changes. If you’re the kind of parent who teaches your children that debt, at least generally speaking, is not a good idea, then you may struggle with how to advise your children when college time approaches.

The changes are part of an executive action president Obama announced called Pay as You Earn.  It is very similar to the new changes coming in the existing Income-Based Repayment (IBR) program.

Pay As You Earn (PAYE)

PAYE redefines how student loan repayment will work. Its provisions are generally effective at the end of 2012. In PAYE, your monthly student loan payment is based almost exclusively on your income after college, regardless of how much student debt you owe when you get out of school. Then any balance, including accrued interest, that is still due at the end of 20 years is forgiven by the government.

The program has its roots in President Obama’s State of the Union address on January 27, 2010, where he said this:

“Let’s tell another one million students that when they graduate, they will be required to pay only 10 percent of their income on student loans, and all of their debt will be forgiven after 20 years – and forgiven after 10 years if they choose a career in public service, because in the United States of America, no one should go broke because they chose to go to college.”

The program is designed to reduce the required monthly payment on a borrower’s student loan based on their income. Generally speaking, if your monthly payment under a 10 year repayment period is greater than the monthly payment PAYE calculates, then you qualify for the program and you make the lower monthly payment.

The monthly payment under PAYE is calculated as 10% of your discretionary income. It defines your income as your Adjusted Gross Income on your federal tax return. It defines discretionary income as 150% of the poverty line for a family of your size. For a single person with no children, the poverty line in 2012 is $11,170. 150% of that number is $16,755. (Those amounts go up if you have children.) So it looks at the difference between your income and the $16,755 to calculate what the government feels you can use to make a monthly payment.

A Borrower Example

A single person with no children making $30,000 (assuming AGI is also $30,000), that comes out of school with $25,000 in student loans, would have a monthly payment of $110. Under the 10 year repayment plan your monthly payment would have been $289. Since the $110 is lower than the $289, you qualify for the plan and would make the lower monthly payment. Any balance still remaining after 20 years would be forgiven by the government.

Here’s a biggie…

The $110 monthly payment in this example would not change even if you graduated with $50,000 in debt (rather than $25,000). It wouldn’t change if you graduated with $100,000. You could graduate with $250,000 in student debt and it would not change the monthly payment as long as the student loans are all loans made by the government. (Note: to get student debt that high through the government would mean you went on to graduate or professional studies after your undergraduate degree.)

Private student loans are not eligible for this program. Parent PLUS loans are not eligible either.

PAYE is setting the monthly payment based almost entirely on your income.

The Good, the Bad and the Ugly

Stay tuned for Part 2 (and beyond) on this subject.

I will list all the good and the bad points that the new Pay As You Earn program and the new IBR program create.

Some are really good… and some are really bad.

The key is for you to determine how this will impact you and your children. That’s what’s most important. I’ll help you accomplish that.