The Massive Scam of Income Based Repayment

CNBCIn response to this article on CNBC today:

https://www.cnbc.com/2018/11/07/rehabilitation-gives-student-loan-borrowers-a-second-chance-at-a-cost.html

Let’s review a few of the important points of our main character, Scott:

1.) Scott graduated with $35,000 in total debt. OK! NOT BAD.

2.) Scott made payments for 10 years, but the balance went up to $55k. NOT GREAT, BOB.

3.) Scott couldn’t make payments for a while, then “rehabilitated” his loan. MAKES SENSE.

4.) Scott now pays $6,300 a year, the balance is going UP every month, owes $130k, and declared bankruptcy which will not help his loan situation at all. WTF!

This story highlights the massive scam of income based repayment. We’ve looked at this problem before:

https://graduatefree.com/2014/11/21/income-based-repayment-and-debt-forgiveness/

and

https://graduatefree.com/2015/09/16/is-the-public-service-loan-forgiveness-plan-a-good-idea/

In that last linked article I said:

These plans often have payments lower than the interest accruing, so the balance on your student loans can actually GO UP over time. This essentially makes you dependent on loan forgiveness as your only way out of debt.

This was one reason why these student loans reminded me of the “negative amortization loans” of the mortgage meltdown.

Even if Scott gets his loans forgiven, he will have paid many multiples of his original borrowed amount ($6k a year x 10 or 20 years, plus the payments he made for 10 years, plus the income tax hit). And again, there isn’t any way out. If you default, the government will withhold basic social safety nets designed for the poor.

This is the payday lending industry re-imagined.

This is indentured servitude.

Please be careful out there.

 

Student Loans: Warnings from the Mortgage Crash

crash_wsj“Default rates identify only a fraction of delinquent borrowers — those who have actually defaulted on their debt. They overlook the much larger shares of borrowers who are neither repaying their loans nor in default….that includes borrowers who are delinquent or whose loans are in deferment or forbearance or in repayment plans in which the balance is growing rather than shrinking.”  (SOURCE)

I began working in the home mortgage business in 2002 and I stayed in that line of work originating new loans right through the economic meltdown of 2008 – a meltdown caused in no small part (primarily even?) by bad home mortgages that defaulted.

I originated “A” mortgages – none of the bad credit or high interest rate loans that dominated the defaults. But prior to 2008, more and more marginal loans were being squeezed into the category of “A” loans. Those loans could then be packaged and sold on Wall Street as “A” paper – even though those of us originating on the street knew better.

Some of the key terms of these ‘marginal’ loans that I originated look stunningly like what I’m seeing in student loans right now. We originated loans that had key characteristics that made them different from traditional 30 year fixed rate mortgage loans:

  • Negative Amortization Loans
  • Interest Only
  • Adjustable Rate Loans (ARMs)
  • Zero Down Payment Loans

I’m seeing eerily similar terms duplicated in student loans right now.

NEGATIVE AMORTIZATION LOANS

Washington Mutual was the biggest supplier of these and anyone could broker loans to them. If you’re not familiar, a Negative Amortization Loan has a minimum payment that is LESS than the interest that is accumulating – meaning that each month the balance of the loan actually goes UP. This ‘snowball’ effect causes you to pay interest on interest causing the balance to rise even faster. It wasn’t a surprise to those of us in the industry when in September of 2008 WaMu was one of the first large banks to be placed into receivership by the FDIC and ultimately their assets were sold to Chase Bank.

A student loan can be set up this way today. If you set up Income Based Repayment (based on a percentage of your income – NOT based on the interest accumulating or the balance of what you actually owe) with a payment LESS than the interest accruing each month the extra interest is rolled into the balance of your loan and the principle of your loan goes UP.

INTEREST ONLY

These loans provide an extremely low payment – just enough to cover the interest on the loan. You can still do a Home Equity Line of Credit (HELOC) on your home with a minimum payment – an “Interest Only Payment” – that just covers the interest.

In student loans, I see a version of this with forbearance and deferment. It is a financial ‘kicking the can down the road’ that doesn’t require the balance to be repaid. For a variety of reasons, you can stop payment on your student loans for a period of time without them becoming delinquent. In some instances, the interest doesn’t stop, it is just rolled into the principle of the loan.

ADJUSTABLE RATE LOANS (ARMs)

Prior to 2008, we had a portfolio of home loan options that offered very loan rates that could adjust in the future. Some of those loans were quite good – the mechanics of the loan caused the interest rates to drop and stay low for years. But an adjustable rate loan is in its nature a loan that passes the risk of future higher rates from the bank to the borrower.

The government has structured student loans in a way that also passes this risk on to the borrower – albeit in a different way. Unlike a home mortgage in the example above, the interest rate on a student loan is fixed for the life of the loan. But the government can change the rate each year – and most students borrow one year at a time through school.

The government is essentially borrowing money through 10 year Treasury Bills at around 2.16% today and lending back to us between 4.29% and 6.84% (WITH additional fees from 1%-4.2%). If the cost to borrow goes up next year, they will pass that risk on to the borrower with higher interest rates. If the cost to borrow goes down, they can lower the current interest rate and still have all the profit from the previously originated loans locked up.

Needless to say, the math on a Trillion Dollars lent at those margins is staggering – Student Loans are EXTREMELY profitable to the government. My back of the napkin math estimates that student loans profit (not revenue, profit) of $51 Billion in 2013 is more than 35 states collected in GROSS federal tax revenue. The entire Federal Department of Education only has a budget of $67 Billion.

Sadly, this amounts to a massive tax on the poor, lower middle class, and those bad at math.

ZERO DOWN LOANS

We originated a lot of 80/20 loans – home purchases that were funded with one mortgage covering 80% of the purchase price, and a second mortgage covering the remaining 20% so the home owner could buy the home without any down payment at all. One of the biggest buyers of these loans was Bear Stearns, and we were even able to do these loans through them on 2nd homes and investment properties. Needless to say when property values dropped, someone owning an investment property in which they didn’t have any of their own actual cash into was quickly moving toward default and foreclosure. Bear Stearns was profitable with $18 Billion in cash reserves on the very day it went bankrupt. Stop for a moment and just think about that.

Current student loan policy allows students to take out 100% of the cost of their education and borrow well above the actual costs for living expenses. This “Buy now, pay later” takes away any financial pain from higher education. Some amount of pain might be a good idea. It may cause the borrower to pause and realize: “This is a big deal. It’s expensive. It’s important. I don’t want to waste this opportunity.”

Conclusion

Layered together, these risks are very difficult to calculate. We are terrible at understanding layers of risk.

The quote I began this article with was taken from this article. It makes the point that Default Rate isn’t a complete picture of student’s ability to repay because of deferment, forbearance, and super low income based repayment options. And it offers this stunning statistic:

At 475 colleges, more than 40 percent of borrowers had not paid a single dollar toward their principal as of three years into repayment, according to a Chronicle analysis. …. At 171 of the 475 colleges, more than half of borrowers were not repaying their loans.

As someone who worked and lived through the pain of a massive reorganization of the entire mortgage industry because of poor lending guidelines, this all sounds very familiar.

Flexibility: Why Debt Hurts Your Income

ball-and-chainIn addition to my original post on Loan Forgiveness, last week I reviewed the Public Service Loan Forgiveness (PSLF) program.

I wanted to blow out one additional thought on the PSLF – but this really applies to all debt, any government program, and your ability to negotiate a higher salary for the rest of your life.

The value of flexibility

The human brain is really poorly equipped to understand opportunity cost.  Opportunity cost – basically the idea that when you do “A”, you forgo the opportunity to also do “B”. For example, if you are a full time student, you forgo the opportunity to work for that year. It’s hard to compare/contrast the value of a degree and a year of formal education versus a year of income and experience. It’s REALLY hard to evaluate today’s opportunity value over the next 20, 30, 40 years.  For example, if you saved $6,000 in that year and it earned 10% over the next 40 years it would be worth $322,000.  Is that more or less valuable than a year of education?

One of the underrated problems of the Public Service Loan Forgiveness plan is that it lock’s you into one job. While it may seem amazing to have $75,000 of debt forgiven, if you really break it out that’s $840 a month or $10,000 a year (including interest). Is it possible through hard work and diligent looking to find a job or alternative stream of income where you can earn an additional $10k a year? Absolutely.

When you find an additional stream of income or develop a skill that serves the community in a way where they are willing to pay you for it, you own that. It transfers with you into new geographic or employment futures. It’s additional financial flexibility provides leverage in the type of jobs you choose to take.

This commitment to flexibility is why one financial guru dislikes home ownership. James Altucher is a secular, contrarian, pot-stirrer that tries to reshape our financial perspectives. Note the reason for his position against home ownership:

You’re trapped. Lets spell out very clearly why the myth of homeownership became religion in the United States. Its because corporations didn’t want their employees to have many job choices. So they encouraged them to own homes. So they can’t move away and get new jobs. Job salaries is a function of supply and demand. If you can’t move, then your supply of jobs  is low. You can’t argue the reverse, since new adults are always competing with you. (source)

His point (among others in the article) is: the Opportunity Cost of homeownership is that the illiquidity of your house prohibits your ability to take a different job outside a very limited geographic area.

Think about that point in the context of the Public Service Loan Forgiveness plan. If your employer knows you have a large student debt burden does that give you more leverage in salary negotiations? Of course not – they know you need a job. Once you have the job, does it put downward pressure on your future income? Sure – they know you are locked in. If your employer knows you need 120 consecutive payments from a qualified 501c3 or you fall out of the PSLF, does that give them additional leverage?

Your employer shouldn’t have that leverage. Even if they know you could go earn $10k-$20k MORE in the non-501c3 market, if you’ve been in the PSLF for four, five, or six years they are pretty confident you won’t leave.

The first rule of negotiating: Whoever has the most ability to walk-away has the leverage.

 

 

 

 

Is the Public Service Loan Forgiveness plan a good idea?

PSLF When I’ve asked students “What is one question I can research or answer for you?”, the topic of student loan forgiveness has come up several times.

While I’ve addressed student loan forgiveness in the past, I haven’t specifically addressed a variation of this: the Public Service Loan Forgiveness (PSLF) plan.

While the traditional loan forgiveness plan takes twenty years and the remaining balance is taxable, under the PSLF plan the balance is forgiven in ten years and isn’t taxable. Given that the primary requirement is working for a 501c3, this seems like an obvious route to go for many going into non-profit work – specifically to those in Seminary going into church work or counseling.

Unfortunately, the PSLF isn’t quite that simple. In fact, if you’re going into missions or occupation ministry it is probably a non-starter. You can download some FAQ’s here, or research more here, but basically there are three main guidelines:

  • Make 120 ‘qualified’ payments
  • Be Employed Full time the entire 10 years
  • Working at “public service” organization

The consideration of these three conditions is very important. One of the great problems of debt is that when it becomes a way of life, the inherent risk isn’t realized until another variable changes. Debt isn’t a problem until you lose your job, have a health emergency, interest rates change, your bank goes out of business, the value of your asset goes down, or any other number of unknown circumstances. Or as Warren Buffett said, “You never know who is skinny dipping until the tide goes out.”

So as we look at these three conditions, keep in the forefront of our minds the risk of time – can we maintain these conditions for 10 years?

Make 120 Qualified Payments

A ‘Qualified’ payment is one that:

You make WHILE employed. You can’t make a qualified payment if you’re laid off, have a couple months between jobs, retire early, are on unemployment, become disabled, etc.

Must be 120 separate payments. You can’t prepay the loan payments, make several payments at the same time, or in any other way ‘jump ahead’ in the plan.

All payments must be on-time. You have to make all the payments within 15 days of the due date or they don’t count as a qualified payment.

Be Employed Full Time

If you aren’t employed as a full time employee, the payments don’t count as a ‘qualified’ payment. This includes any time you might be between jobs, your company goes out of business, you take some time off to have children, or any other reason you might be out of the workplace.

Working at a “Public Service” organization

This includes most 501c3 and all government organizations. This might not be an issue if you plan on being a public school teacher, or work as a counselor for the county Family Services. These jobs are longer career tracks in more stable environments.

But for most non-profit work this is a mess. The turnover rate in non-profit work is high. Non-profits can close or go under if they lose funding. These positions also chronically underpay, so it may be likely that you’re offered a position in a for-profit field at a significant salary increase.

If you plan on working in a church, there is a clause specifically to prevent most church employment jobs. The rules for churches are clearly explained:

Question: I am employed full-time by a qualifying not-for-profit organization that engages in religious activities. Does my employment qualify for PSLF?
Answer: It depends on how much of your job is related to religious activities. When determining full-time public service employment you may not include time spent on participating in religious instruction, worship services, or any form of proselytizing

This basically makes this program unavailable for anyone working in a church or most para-church ministries – including ANY ministry based in another country.

An email from one of our partner institutions summarized this well:

“Recently I’ve been hearing more and more about loan forgiveness after 10 years if you work for a non-profit, and it seems that the general impression out there is that this will apply to our students working in churches, which are 501(c)3 non-profit organizations.

 This didn’t sound right to our financial aid officer or me, so we tracked it down.  The short answer is NO, M.Div. graduates will not qualify for loan forgiveness unless they work at a completely secular organization for 10 years (and then what is the point of an M.Div.?). ”

OTHER PROBLEMS:

In addition to the litany of issues listed above, there are a couple of other issues that I see:

You have to make less than the ‘regular’ payment

The ‘standard’ repayment plan for a student loan is a 10 year repayment plan. So to have a balance left at the end of that period, you have to have applied and been approved for reduced payments through the Pay-As-You-Earn or Income Based Repayment plans. These plans often have payments lower than the interest accruing, so the balance on your student loans can actually GO UP over time. This essentially makes you dependent on loan forgiveness as your only way out of debt. The problem with this is:

You have no job flexibility

If you have student loans with interest accruing faster than you’re paying it, rising balances that you legally can’t bankrupt out of, and you’re forced to work for the government for a minimum of 10 years this is starting to sound like indentured servitude. At least those in ancient Israel that sold themselves into slavery were supposed to be freed every seven years.

You can’t consolidate during the 10 years

This isn’t a huge deal, but it is a consideration.

It’s possible the government could change the rules

This may be unlikely, but it’s a lot of eggs to put in the basket of two administrations from now.

By nature of the program, extra payments are extremely discouraged.

If your eggs are in this basket, any extra principle payments essentially feel like throwing money away. You can’t finish earlier than 120 payments and 10 years.

No partial forgiveness

If you follow the program flawlessly for 9 years and some circumstance changes that doesn’t allow you to finish the program there is no ‘meet in the middle’. You just don’t qualify.

It discourages making money

Because minimum payments are based on income, if you make ‘too much money’ you will be required to make a payment that is more in line with the Standard Repayment. I’m not a big fan of setting up systems that penalize success.

It encourages high levels of borrowing

If students are considering this as their primary (and truly only) route to loan repayment, they are far more likely to borrow significantly more than the cost of their tuition.

Conclusion

For these reasons, the reasons I had previously outlined, and my belief that God values freedom, I don’t recommend pursing this as your loan repayment plan. If you find yourself in a position (say as a school teacher) that you enjoy, don’t plan on leaving, and that qualifies for the PSLF, I don’t see any ethical problem in taking advantage of the program. In that situation, I would recommend aggressively saving money in a separate savings account so that if the situation arose where you were unable to finish the 10 years/120 payments, you could write a check and pay off the balance.

Research Findings

graph graphicOne of the ATS partner divinity schools did a comprehensive survey to learn more about the financial realities of their students. Here are some of their findings:

  • Length of time to degree completion does not appear to significantly affect debt levels (though we had a very small sample on this question).
  • Students over 31 years of age were significantly (almost 3x) more likely to borrow high levels of debt (over $50k).
  • Underrepresented minorities (Hispanics, Black or African American, American Indian or Alaskan Native, Native Hawaiian or other Pacific Islander, or those with two or more races) were significantly more likely to report high levels of debt ($50k or more).
  • Married/Partnered students were significantly more likely to report no debt when compared to students who are single, separated, or divorced.
  • Students with dependents were more likely to report high levels of debt (over $50k) compared to their peers with zero dependents.
  • Whether a student owns or rents their residence did not have a significant effect on debt levels.
  • Students who lived with roommates and shared expenses were significantly less likely to report high levels of debt (over $50k) when compared to students who live alone.
  • Respondents with high levels of debt (over $50k) indicated they expect a higher salary than their low debt peers.
  • Over 50% of respondents indicate they have zero consumer debt, and the vast majority (83%) of those with consumer debt indicate that the debt is under $20,000.
  • 44% of respondents plan to be bi-vocational following graduation.
  • 76% agree or strongly agree that they will be able to repay their debt.
  • 65.6% indicate that their level of debt is acceptable or very acceptable.
  • 77% of respondents plan to use a standard loan repayment plan, 42% plan to use PAYE or income based repayment plans, and 8% either have no plan for repayment or do not plan to repay.
  • Students with high debt (over $50k) are significantly less likely than their lower-debt peers to indicate that their level of debt is acceptable when considering the quality of the graduate education received.

I think it raises interesting questions about segments of the populace who are financially vulnerable.

Income Based Repayment and Debt Forgiveness

IndenturedThis 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.

2X Income

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:

 

80k in Student Loans on 40k salary

Let’s look at the most common choices:

  1. 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.
  2. 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.
  3. 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.

Problems:

A deep dive into the numbers alerts me to a couple of major financial mountains that can cause long term financial harm:

  1. 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.
  2. 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.
  3. 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.

3X Income

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:

 

120k student loans on 40k income

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.