The Dark Side of Student Loan Repayment Plans

Student loan debt in the US has risen to $1.3 trillion. At the end of 2015, seven in ten graduating seniors had student loan debt with an average balance of $35,000. The percent of students borrowing was up from 2005 by 5%, but 20% more than in 1995, according to an article by the Wall Street Journal.

In response to the growing student debt problem, in 2011, President Obama issued an executive order creating new repayment plans that were based on discretionary income for any loans outstanding taken out after 2008. The first Income Based Repayment (IBR) plan became available in 2009, capping payments at 15% of income, but these new plans limited payments to 10% of discretionary income and extended the repayment time to 20 years for undergraduate debt (25 years if graduate school debt is included) from the standard 10 year repayment plan. And if any part of the debt remained unpaid at the end of the new longer repayment period, it would be forgiven.

A collective sigh of relief was nearly audible from the debt burdened hoards of recent college graduates. These plans could substantially lower monthly payments. A graduate with $30,000 in loans and a $25,000 annual income could see her payments lowered from $333 per month to $190 per month according to the example provided by the Federal Student Aid Office of the US Department of Education. Payments could be nothing if income is low enough. Taking advantage of these programs can certainly make life easier while you are getting started in your career.

But they have a dark side for those whose situations don’t work out as planned. If your payments, as determined by the income calculation, are less than the interest on the loan, the amount of interest that isn’t paid is capitalized, which means it is tacked on to the loan as additional debt. As a result your loan is growing, not declining, even as you make payments. If you are out of work or return to school and are therefore not required to make payments, your loans continue to grow by the amount of the annual interest.

No problem you say. Whatever is left over after 20 years is forgiven, right? Yes, that is true. However you may not want to be forgiven in this way. Any forgiven balance on your loan becomes taxable income in the year the debt is cancelled under Section 61(a)(12) of the Internal Revenue Code. There is an exception for loan programs where the loan is forgiven after working for the government or for a non profit for an agreed upon number of years. For any other student loan, having any part of the loan forgiven can be a serious tax burden for you. Think about it. Your income in that year will be much higher than your usual income, but you will not have any extra cash flow with which to pay the taxes.

These are important considerations for anyone thinking about taking out student loans, for themselves or their child, and for anyone struggling to make a payment. If you haven’t taken out the loans yet, you must understand that borrowing for an education, like any borrowing, comes with risks. You owe the debt regardless of whether your income can support it.

There is evidence to suggest that students taking out loans don’t know what they are getting into. A study by the Federal Reserve Bank of New York found that fewer than half of students with loans had a good understanding of the fundamentals of debt. The number of anecdotes that I hear and read about people being shocked by their loan balance and payment size, as well as the fact that the loans grow if you don’t make payments and you can’t discharge them through bankruptcy, just confirms this.

Concerned about the rise in student loan balances, Indiana University began sending notices to students in the 2012-2013 school year showing them how much they had borrowed to date and how much their payments would be at graduation. After receiving the notices, students at the university took out 11% less in loans than they did in the prior year. Understanding what they were getting into helped motivate students to look for alternatives.

If you or your child are planning to take out a student loan think about these questions:

  1. Will your chosen profession reasonably pay you enough to allow you to afford the loan payments? Can you get the same degree at a lower cost institution?
  2. Is there anything that you can do to minimize the amount of loans you take out?Things like choosing a lower cost school, attending community college or working at a part-time job are all good options.
  3. Are you truly committed to the program and the profession? You still owe the money, even if you don’t get the degree. More than 20% of students in public four year institutions, who took on debt, didn’t finish the program. The number was higher for four year for-profit programs, at a startling 54%, according to a study by the Education Policy Center at the American Institute for Research.

Already graduated and struggling with student loan debt? Even if you qualify for low or no payments under one of the income based repayment programs, pay as much as you can. If you can at least make the interest payment, you can stop the loan from growing and reduce your required payment when your income goes up. If you are making the required payment, set a goal to pay extra. If you are already covering the interest with the required payment, every cent of the extra payment reduces the principal. That shortens the time it takes to repay the loan and return some of your financial freedom.

A college education is a big investment that generally is well worth it. However, taking out a student loan to pay for it should be a last resort. Like any other form of debt, it increases the risks to your long term financial security. While income based repayment plans can make the burden of payments easier to bear, they have a dark side. Understanding the terms of your repayment plan and actively managing your outstanding balance can help reduce the risks.

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