Student loans are big business for the federal government. The total national amount of student loans is now over $1.2 trillion. The federal government owns the vast majority of those loans. And that means the government is raking in, at a hypothetical average rate of 6%, some $70+ billion per year. And the government is encouraging this rapid expansion in student loan debt by telling graduate students that they can borrow the total cost of their education, including books, housing, and tuition, and encouraging parents to borrow money for their undergraduates. In turn, the schools have responded by jacking up tuition every single year at an average pace of 5% per year, resulting in a 221% increase in the average cost of private college since 1975, and a 294% increase in the average cost of a public university education in the same period.
The results of this madness are $1.2 trillion in loans that are non-dischargeable in bankruptcy, and, as it turns out, aren’t really forgiven for the vast majority of borrowers at the close of the pay as you earn (PAYE) or income-based repayment (IBR) plans after 20 or 25 years of diligent but insufficient payments.
But suppose you do get one of these positions. Are you really ready to commit to working for the government or non-profit sector for 10 years? What happens if your non-profit folds? What happens if the government lays people off, or Congress decides to change the rules about public sector loan forgiveness? Ten years is a big bet, especially in a political climate where Congress can’t even pass a budget without coming close to (or actually) shutting the government down.
The second premise is that if you fail to repay your loans in full after 20 (PAYE) or 25 years (IBR), any remainder will be forgiven. Great deal, right? If things work out and you pay off the loans, both you and the government win. If things don’t work out and you can’t find a job based on your education, and you fail to repay the loans in full, the government takes the hit, which it can afford to do trying to stimulate the economy.
Unfortunately this whole premise is a total lie. Your loans are forgiven only in the sense that your new student loan servicer is the IRS, because the IRS will consider all that forgiven debt taxable income—unless you meet the stringent requirements of the public service forgiveness discussed above. So, what you’re really getting is not forgiveness but a ~60–75% discount on the amount you owe, coupled with a new creditor armed with a massive ability to get at your assets and an immediate demand for payment in full of what remains after the “discount,” at a time in your life when you should be approaching retirement.
Compounding that problem, it’s possible (even encouraged!) that eligible borrowers make minimum payments on their loans, which often means they are not making payments that cover all the accruing interest. That means that not only are these borrowers not chipping away at their loans, their debts are actually growing the longer they work and make their monthly payments. Then, to celebrate 20 or 25 years of payments, their debt is “forgiven,” resulting in a new, massive tax obligation to the IRS for all of that “income.”
To illustrate this point, let’s take the case of a hypothetical student loan borrower. Sally completes four years of undergraduate school at a prestigious private college, taking out $50,000 in loans along the way, at 6% interest. She decides to work for her small family business. The work is rewarding in many ways, but not monetarily. She makes $200 payments every month, but that is less than the $250/month accruing in interest. She makes her payments for ten years, but then forgets to re-certify in the tenth year for the IBR plan. All of the unpaid interest is capitalized. Now she owes $56,000 in principal instead of $50,000, after making $24,000 in payments.
Sally manages to get back on the IBR plan quickly, and her payments remain the same because her income has not changed. Her $200 payments are still less than the $280 in interest accruing each month. She makes those payments regularly for the next 15 years. But by that time the balance of her loans has increased to $70,400. Luckily, she thinks, this debt will be forgiven. After all, she paid $60,000 over 25 years—she held up her end of the bargain. Unfortunately, now the IRS says she owes it $17,600 just for the tax year in which her debts were forgiven. This likely means she either doesn’t have the money, or she has to withdraw a significant amount from retirement savings—perhaps at a tax penalty!—to pay this amount on time, or worse, sell her home, or cars. If she doesn’t pay it, then the IRS begins to attempt to collect it.
Unlike an unsecured student loan lender, the IRS has a vast network at its disposal to enforce debt owed to it. It can place a tax lien on Sally’s property. Saved up equity in her home? It’s likely gone, and the IRS eventually can foreclose on the home. The IRS can also garnish her paycheck. Additionally, the IRS can “take money in [her] bank or other financial account, seize and sell [her] vehicle(s), . . . and other personal property.”
So, even in the worst case scenario for the government in this hypothetical, it eventually gets $77,600 out of its $50,000 investment. Meanwhile, Sally potentially loses her retirement savings, her home, and/or her cars due to her “forgiven” debt. Sounds fair, right?
If you think you’re falling into the trap waiting for Sally, you have a few options. If the interest rate on your student loans is relatively low, the best strategy is to figure out how to pay off your loans as quickly as possible. Sticking with your federal loans if your interest rate is below the prime rate (3.25%) does provide certain risk protections if your income changes dramatically from losing your job, although usually at the cost of capitalizing all accrued interest during whatever period of deferment/nonpayment.
If, however, your interest rate is over the prime rate (3.25% as of this writing), refinancing with a private lender like SoFi could help you lower your monthly payments and your repayment term. My interest rate dropped from an average of 7.4% with a potential repayment term on the IBR plan of 25 years, to a 15-year plan with a 3.825% rate, saving me over $100,000 in interest, and avoiding the potential tax penalty for my loan “forgiveness.” In addition, SoFi has a support network to help you look for a new job if you lose yours, and if you die or become permanently disabled they will cancel your loan. (Other private lenders I looked into wanted my spouse to co-sign for the loan, thus taking on the full burden even if I died. No thanks.) Finally, they’ll let you refinance with them as many times as you want into a lower rate, and currently they have no origination fees.
Having a mass of student loans at the beginning your career is a burden. But it shouldn’t be made worse by government usury and hidden tax penalties.