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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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!

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. :-)

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.

Maybe President Obama is right about student loans

Every week in this blog I encourage you to avoid student loans for yourself and for your children.

But, what if I’m wrong?

What if borrowing on student loans is smart? What if you really can’t get a college education any more without taking on student debt?

What if your child should be able to go to any college they want regardless of the cost?

Maybe President Obama is right about student loans and making them more attractive to students and parents. He has been quoted on a number of occasions during his re-election campaign this year saying:

“No family should have to set aside a college acceptance letter because they don’t have the money”. President Obama

Most politicians say similar things, especially during an election cycle. And the government provides almost 90% of all student loans in America now.

Maybe it is OK to let your child attend Princeton rather than your state school even if you can’t afford it? Maybe money should not be an issue when it comes to your education or the education of your children.

Maybe the politicians, the ones lending you the money, are right?

Are you really going to turn down money from someone who has lots of it and wants to give you some of it? Especially when they don’t really care how much you want. They will give it to you. All you have to do is ask.

And the new Pay As You Earn program is going to make paying the money back even easier. (More about that new program in future blog posts.)

Wow, maybe this free money (student loan) thing is the best thing since sliced bread.

:-)