DEBT AS SOCIAL JUSTICE

words on justice.jpg Articles like this make me angry when they use a college education as the “carrot on a stick” that makes student loans a good thing:

“Student loan debt is also an investment in your future. Simply put, you will be more employable and earn more with a college degree.”

I believe this is a straw man. The argument for or against a college degree is irrelevant to the structural problems that student debt brings. I believe that student loan debt is a social problem, a social justice problem even, because it is most egregiously harmful to very specific segments of our society.

  • 1 out of 3 student loan borrowers don’t graduate. This immediate invalidates the ‘college is worth the debt’ argument. If as many as a third of borrowers aren’t graduating, they are stuck with debt they can’t get out of and no increased earning potential. There is myriad of reasons they might not be graduating, including being poorly trained for college, health, financial, family instability, substance abuse (yo Madison!), and more. More on that here.
  • If I default, the government will withhold low-income benefits. Because the government is the debt collector, if I default on my student loan debt the government will withhold my tax returns (including Earned Income Tax Credit and Social Security benefits). These social safety nets aren’t a big deal if I’m wealthy, but it’s devastating if I’m poor. Between the socio-economic classes (rich and poor), who is more likely to default?
  • The highly indebted are borrowing even more. We’ve discussed before that there is a bifurcation of healthy borrowers and unhealthy borrowers. The healthy borrowers borrowing is remaining level, but the unhealthy borrowers are borrowing even more than before. Some estimates put these borrowers at around 17% of all borrowers. In my experience, this sounds about right. We know that if you are female, of color, or an older student you are significantly more likely to be a highly indebted borrower.
  • Borrowing to make an “Investment” is extremely dangerous. Quoting a 15% financial rate of return is just lying if it doesn’t take into account borrowers who don’t graduate and the higher interest rates and fees on defaulted student loans. If you can’t bankrupt out of a ‘bad investment’, it can cause decades of pain for defaulted borrowers. High returns don’t mitigate risk. This is why the lottery is a bad investment. A potential 15% ROI doesn’t offset the inherent risks of student loan borrowing.

So to summarize, “it’s okay to have student loan debt!” as long as you’re intelligent (with an aptitude for intellectual studies, healthy family structures, and safety nets that allow you to graduate), are not poor, and are not a woman or minority.

There are a variety of potential improvements that could be made on the legislative level (realistic hard cap on borrowing, lower interest rates, larger Pell grants, allowing bankruptcy), but these are out of our ability to change right now.

Instead, let’s focus on personal behaviors I can change RIGHT NOW to reduce my risk of being a statistic. These include borrowing as little as possible, fully understanding my current situation and risks, and building healthy personal financial habits.

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.

 

 

 

 

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.