The Student Loan Forgiveness Trap…

Why High-Debt, Private Sector Borrowers Must Think Twice Before Hopping on the Income-Based, Loan Forgiveness Track.

Earlier this week, President Obama signed an executive order in which he included a provision recommending an expansion of the current “Pay-As-You-Earn” or (“PAYE”) student loan program to an additional 5 million borrowers. The key features of the PAYE program are two-fold: (1) it caps payments on certain Federal student loans to 10% of the borrower’s discretionary income; and (2) it provides for loan forgiveness to those borrowers who have unpaid principal and/or interest at the end of either 10 (if they have worked for 10 years in a public service job) or 20 years (for those who have not attained 10 years in the public sector by that time).

The Executive Order was celebrated as a victory in the battle to ease the student loan debt burden on the American people, debt which has now reached heights of around $1 Trillion nationwide. The White House issued a report stating that most of today’s borrowers would qualify for some type of break on their loan payments under the program. And, following the announcement, several media outlets, including NPR identified only a single flaw in the Program itself: that “few people have actually signed up for it.”

So, it all sounds so good, right? Pay what you can now based on whatever discretionary earnings you have, and if you can’t pay for all of it in 20 years, so what, it’s forgiven. Well, I say, not so fast.

Hidden beneath the applause and the buzz words sit the fine print and the reality that, especially with respect to high-debt borrowers, enrollment in PAYE and other similar programs might not simply be a bad idea, it almost surely will be financially disastrous.

What is this fine print, you ask? Well, here is the catch: Any loan forgiveness that is not obtained related to public service is 100% taxable by the federal government (IRS) in the year it is forgiven. Scared yet? If not, let me explain why you should be.

I stress that every borrower looking to pay only based upon what he or she earns and is looking ahead to the loan forgiveness after 20 years should be concerned about this issue. However, the truly devastating consequences exist for high-debt borrowers, those with debt anywhere from $50,000.00-$150,000 and beyond. And, if you think this is only a minuscule number of borrowers, think again. A recent US News study reported that 25% of graduate students leave school with debt of $100,000 or more. Graduate student debt represents nearly 40% of the $1 Trillion in total debt. Finally, graduate students represent 16-20% of the higher ed. student population in the Country. That’s a substantial number.

So let me describe the problem using an example. Let’s say a graduate student had finished school with debt of $100,000 from all of his education combined (which is likely, see above), and all of that debt is in the form of federal loans at an interest rate of 6.8% (all of which is, additionally, likely). The standard repayment option over 10 years is $1,150 per month. That’s scary for most people. Even at a 20 year repayment, that number decreases only to $763 per month. Still quite a chunk of change every month.

Now, according to the Government and others, just add PAYE into the mix to alleviate all your worries. Under the example, let’s say that the borrower was living alone and earning $55,000.00. (This, again, is realistic. It’s important to remember that salaries, even for those with graduate degrees, are not only stagnating but in some cases are decreasing. Those with graduate degrees include many people in lower wage jobs in the private sector.) At a salary of $55,000, your “capped” PAYE payment would be $312 per month.

Now here is why PAYE presents a problem and not a solution for many high-debt borrowers: At $312 per month , the person in the example is not even paying one-third of the monthly amount of the loan. And here is the real kicker: interest continues to accrue. (Although PAYE tries to limit interest from accruing under such circumstances, it is not non-existent, and with a large student loan, accruing interest is substantial.) On the $100,000.00 loan, interest accrues at a rate of $560 per month. Thus, while you are paying only $312 on the loan under PAYE, the interest on the loan itself continues to rise, and quickly!

This can get out of control, rapidly raising your student loan debt substantially. Even with the interest cost control measures (which are not all that impressive when you truly examine them) of PAYE, you are still looking at paying mountains of interest and risking not paying down much of your principal at all, even by the end of the 20 year period. In other words, from the start, you are falling farther and farther behind.

And, whatever you have not paid down after the 20 years stacks directly on top of your income and is taxed in the year the loan is forgiven; no exceptions. That is, if you have failed to pay 35, 40, or even $50,000.00 of the loan principal, then that amount is added to your income, most likely bumps you up a few tax brackets, and the government comes calling for its extra “slice of the pie.” If you cannot pay it, here are just a few of the steps the IRS can take: (1) garnish your wages; (2) put a lien on your home; and (3)seize personal property, such as vehicles.

My intention is not to scare borrowers here. Yet, everyone must face the harsh reality of their own student loan debt and must look realistically at the options they have to minimize the overall cost. (After three years of law school, I certainly had to.) Every borrower needs to be aware of the consequences of paying only according to what he or she is currently making under the PAYE program and relying upon the 20 year loan forgiveness.

In the end, although these student loan programs may work for some and certainly sound nice coming from the President at a press conference, high-debt borrowers need to think long and hard before choosing to pay less than the principal balance from the start. If consideration of this issue is not considered at the beginning, the consequences at the end of the day may very well be disastrous.