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. :-)