This morning a student was referred to our Financial Coaching Program who had $127,000 in debt. Wow. As I’ve talked with several students who have accumulated large amounts of student loan debt, a common answer to “What is your plan?” is “I’ll just make the minimum payments in the Income Based Repayment plan and I’ll have the balances forgiven after 20 years.”
A quick zoom through StudentAid.gov shows that the minimum payments are affordable, so on the surface this plan seems to work. But my anti-debt antenna was going bonkers so I thought this deserved a deeper dive.
To begin, let’s define ‘large’ amounts of student loan debt. While no debt at all is far and away the best route to go, when does the total debt become burdensome? To answer that, we look at two sides of the equation – Future Income and Debt Balance. If your starting income is going to be $63,400 like these local graduates, then your definition of ‘large’ and ‘manageable’ is going to be different from a youth pastor with a starting salary of $40k. I find it helpful to think through total debt as a multiple of your starting salary. So if your starting salary is estimated at $40k, $40k in student loans is 1x, $80k is 2x, and $120k is 3x.
By casual observation, sifting through the finances of over 2,000 families over the past 12 years, indicates that you can generally manage to pay off student loans of less than 1x your starting salary in a reasonable amount of time by sacrificing – but without egregious hardship. The good news for a school like Denver Seminary is that currently about 75% of the students are graduating with that much debt or less.
However, as the debt levels go up from there, I have legitimate concerns that the students taking on this liability haven’t fully processed the financial cost. It is statements like the one in the first paragraph – folks depending on student loan forgiveness from the government as a plan for getting out of debt – that prompt this post.
Role play with me: You graduate, land your job, and start to calculate your student loan payment options on an $80k debt with a starting salary of $40k. Those numbers look like this:
Let’s look at the most common choices:
- Standard: This route is a fixed payment of $896 a month for the next 10 years. If you’re making $40k a year, that’s $3,333 a month. With a conservative amount for taxes and health insurance you should take home around $2700 a month. $896 is 1/3 of your take home pay. That leaves about $1800 for housing, transportation, food, cell phone, insurance, and skinny jeans.
- Extended Fixed: This extends the repayment period over 25 years while increasing the total amount paid by $50,024. I don’t think this route has much traction.
- Pay As You Earn/Income-Based Repayment. These options are indexed as 10-15% of your discretionary income, expected to go up as your income goes up.
A deep dive into the numbers alerts me to a couple of major financial mountains that can cause long term financial harm:
- Current interest rates are 6.21%. The minimum payment just to cover the interest rate is $414 a month. Anything less than that and the balance actually rises – which is why several options show ‘Projected Loan Forgiveness’. Any repayment plan that doesn’t cover the cost of the interest essentially forces the borrower into a 20 year cycle of indentured servitude. Even Jacob when he got screwed by his father in-law only had to work 7 years.
- The numbers on the far right – “Total Amount Paid” don’t tell the entire story. Take the 10 year flat pay. If you didn’t have student loan debt, but rather invested the $896 for 10 years at a very conservative 8% return, you would have a total of $163,919 in cash. On the extended fixed over 25 years, you would have $499,288! That’s a half a million dollar net worth difference – its $420,000 more than and the original $80k borrowed – it is the difference between financial legacies.
- Most people that look at this look at the “Pay As You Earn” option and say, “$83,765 over 20 years isn’t too bad – it’s just a little more than I originally borrowed”. Again, these numbers are incomplete. As current legislation exists, the $95k in projected loan forgiveness is a taxable event. So if you’re making $60k a year, for one year you will have a taxable income of $155k – putting you into a significantly higher tax bracket. After deductions, that will leave you with a tax bill of around $27,000. I probably don’t have to tell you that most folks would have a hard time writing a $27,000 check. IRS tax liens are super nasty – to the point where Dave Ramsey says he’d rather owe the money on a credit card than owe the IRS. When you add the tax liability, the interest owed on the tax liability, the $83k in actual cash paid over the 20 years that could have been invested, the “Pay As You Earn” option begins to look a lot more expensive.
Compound interest has been compared to a snowball rolling downhill. Just get it started and it gains enormous size and momentum over time. Large amounts of debt are that illustration in reverse. As the balance of the debt gets bigger, the accruing interest becomes harder and harder to escape.
As the total accumulated debt approaches and passes the six figure mark, it becomes closer to 3x expected income. What do the numbers look like for $120k in debt on a $40k starting salary? Here is what that scenario would look like:
Standard repayment is around ½ take home pay. If you averaged 10% returns, investing the Extended Fixed payment would make you a Millionaire over 25 years. The potential tax liability on the Projected Loan Forgiveness of $185k would be approaching $40,000.
Depending on low Income Based payments and Loan Forgiveness to wipe out student loans is an awful game plan for life. A more realistic plan for financing higher education is needed to prevent a lifetime adversarial relationship with money.