I have written several times in recent months about student loan debt, a subject near and dear to the hearts of many students and their parents and also one of pressing national importance here in the US. My posts have been triggered for the most part by a series of interesting articles published in The Wall Street Journal discussing various aspects of our national student loan debt problem. I am writing again today in response to another recent WSJ article on this topic, which explores the workings of student loan Income-Based Repayment Plans (IBRPs), under the title Why Student Debt Keeps Growing—Even When Borrowers Keep Paying.
This most recent WSJ article explains the workings of a particular federal student loan IBRP, the Revised Pay As You Earn (REPAYE) Plan. Although REPAYE isn’t the only such repayment plan offered by the federal government, the details of which are each somewhat different, it offers us a good look into how these various IBRPs work. IBRPs allow qualified student loan borrowers—in the case of REPAYE those with low to moderate incomes but relatively high grad-school student loan debt— to cap the amount of their required loan repayments at a fixed percentage of their income and to stretch out their payments over long period of time, with some or all of the unpaid loan balance cancelled upon successful completion of the program.
The tenor of the WSJ article seems somewhat critical of these IBRPs, or at least of REPAYE, suggesting at least implicitly that the student loan borrowers who participate in these plans are somehow getting hoodwinked into paying more than they should or more than they can afford. In the very first sentence of the article, the authors ask somewhat provocatively “How does a graduate student loan balance get out of control, despite years of dutiful payments?” The article goes on to explain how this happens, but again with a perhaps subtle implication that something nefarious is going on here, to the participating borrowers’ detriment.
But in reviewing the numerical analysis provided by the WSJ, it looks to me like those student loan borrowers who qualify for participation in REPAYE are getting a very good deal indeed. And they are certainly getting a better deal than those student loan borrowers who do not qualify for participation in an IBRP and have to struggle financially over many years in order to repay their student loans in full and on time.
We can all debate whether IBRPs are or are not a good thing from a public policy perspective—and I will offer a few preliminary observations on this question at the end of my note—but before we do that let’s first make sure we understand how these plans work, using the REPAYE example helpfully laid out in the WSJ article cited above.
The WSJ article profiles a hypothetical student loan borrower who qualifies for participation in the REPAYE plan and successfully completes the program by making low but growing monthly payments over a 25-year period, at which point the unpaid balance of his loan is forgiven. This student initially borrows $150,000 in federal student loans to finance his tuition and living expenses while in graduate school. The money is borrowed under two federal loan programs available to grad students and the loans accrue interest at a blended rate of 6% or so. Interest on a portion of the loans begins to accrue while the student is still in grad school with the balance accruing interest only after graduation. Because no payment of principal or accrued interest is required of the borrower until after graduation, however, the principal amount owed at graduation will have increased to about $170,000 including accrued interest and fees. The WSJ analysis assumes that this student enters the REPAYE program immediately after graduation and qualifies due to the low amount of his income relative to the large amount of his grad-school loan debt, in this case a starting salary of $65,000 a year growing at 4% annually over the next 25 years.
Before we look at the repayment economics for our hypothetical REPAYE participant, however, let’s remind ourselves how this would work for a student borrower who does not qualify for participation in REPAYE or another IBRP, perhaps because their income is too high or the amount of their debt too low (relative to their income). A non-qualifying student loan borrower graduating with this same amount of debt at the same rate of interest would normally be expected to repay his loans over a 10-year amortization (repayment) schedule, in which case the required payments would be about $1,900 a month. The borrower’s fixed monthly payments would go first to pay accrued interest and then to amortize the principal amount of the loan; in early years the payments would be mostly interest and in later years they would be mostly principal. (This is also how a traditional 30-year fixed rate amortizing mortgage works.) After ten years of full and timely payments, the loan would be paid off in its entirety. This student borrower would have repaid the $150,000 initially borrowed plus about $76,000 of cumulative interest, for total payments over the 10-year period of about $226,000.
Not all graduates earn enough money to make these regular monthly payments consistently over a 10-year period, however. Those who cannot do so may opt into a deferred repayment plan which allows them to pay off their loans over a longer period of up to 20 years, at a lower monthly payment amount but with more cumulative interest accrued (and paid) over the longer repayment period. For those who choose to repay their loans over the full 20-year amortization period, the required monthly payment would be lower, about $1,200 a month, but the total amount of interest paid over the longer repayment period would be much higher, about $142,000 in our example. This borrower would have made total payments over the 20-year period of $292,000 (including the initial $150,000 principal amount).
Repaying student loans over a longer amortization period may or may not make sense for the borrowers depending on how much they earn, how quickly they expect their income to grow, how much they can afford to repay, and what else they might choose to do with their money at any given point in time (eg form a family or pay off high-cost credit card debt). And these factors often change significantly over the course of a few years and particularly over 10 or 20-year period. Borrowers who find themselves with a bit of excess cash can always voluntarily pay down the principal on their student loans, without penalty, regardless of what amortization schedule they initially choose.
But many student loan borrowers cannot afford to make even the lower fixed monthly payments required under a 20-year amortization schedule, and for those who qualify the federal government provides alternative IBRPs such as REPAYE. It appears that there are currently over 8.5 million student loan borrowers enrolled in these IBRPs, and many millions more who have temporarily seen their student loan payments suspended under Covid relief legislation which will soon expire.
Under the REPAYE plan, the borrower pays a set percentage (10%) of his “discretionary earnings”, defined as the amount of earnings over 150% of the federal poverty level, which for a single individual with no children is currently about $13,000 a year or $1,100 a month. (This is the amount of the federal poverty level, not 150% of the poverty level.) The amount of the borrower’s required loan payment fluctuates annually with the borrower’s income and changes in the federal poverty level baseline. Mandatory loan repayments continue for 25 years, after which any remaining unpaid balance on the loans is forgiven by the federal government.
In the WSJ example, the student loan REPAYE participant earns a starting salary of $65,000 a year upon graduation, which is about $5,400 a month (pre-tax). Under current regulations, this student loan borrower qualifies for REPAYE due to the large size of his grad school loans ($150,000) relative to his moderate income (about twice the US median). By participating in REPAYE, the borrower’s initial required monthly payments would be less than $400 a month (my estimate), growing with his income at an assumed rate of 4% a year to about $535 a month in year ten (WSJ estimate). Because these monthly payments are substantially less than the amount of interest accrued on the loans—which was already $850 a month at graduation— and because the interest rate on the loans (6%) is higher than the annual growth rate of the student’s income and monthly payments (4%), the unpaid accrued interest owed by the student increases substantially over time, adding to the principal amount of the loan. This is a classic example of the workings of compound interest, a phenomenon which every finance student— and all student loan or credit card borrowers— should understand.
When we put all of this together, it appears that our hypothetical REPAYE participant will over 25 years have paid on his initial $150,000 loan(s) around $185,000 of cumulative interest, compared to $76,000 for the 10-year borrower and $142,000 for the 20-year borrower. This $185,000 of cumulative interest may seem like a lot to pay on a $150,000 loan, and it is much higher than the amount of interest paid by those who paid off their loans more quickly, but does this higher interest bill make REPAYE a bad deal for the borrower?
No, of course not, for several reasons. First, this $185,000 of cumulative interest paid by the REPAYE participant is less than the total amount of interest which actually accrued on the loans, due to the federal cap on monthly payments, in our example by a total amount of $50,000. Second, the REPAYE participant repaid his loans over 25-years, not 10+ years, and without any principal payment over this period the cumulative amount of accrued interest would obviously be higher than for the shorter-term loans, even had the borrower stayed current on his interest bill. This is not unfair; it is just how loans work. And third, the REPAYE participant will have made his loan repayments at a much reduced initial (but growing) rate over a longer period of time than the non-qualifying borrowers, and so with the benefit of inflation will have serviced his loan with much cheaper “real” dollars. As we have learned in school, and throughout history, inflation is the friend of debtors and the enemy of lenders, and this is no different with student loans.
But the main reason that REPAYE is such a good deal for the borrower is because at the end of the 25-year period, the entire unpaid amount of $200,000 ($150,000 of initial principal amount plus that $50,000 of accrued but unpaid interest) will be forgiven, complements of the federal government (ie the US taxpayer). As you might expect, this loan forgiveness feature of the program dramatically improves the economics of student loan debt for qualifying borrowers.
I don’t know about you, but if someone told me I could borrow $150,000 to fund my grad-school education and repay the loan at a much-reduced (but growing) initial rate over 25 years for a nominal (not inflation-adjusted) cost of just $35,000 over the amount initially borrowed, I would do it in a heartbeat. In fact I would try to borrow more. And so would you. We would be nuts not to.
As in much of life, however, there is no such thing as a free lunch even when we are talking about federal government programs. Participation in the REPAYE plan is only available for grad-school borrowers with low to moderate incomes and relatively large amounts of student loan debt. And this is not a good place to find oneself upon graduation, with big student loan debts and a low and uncertain future income. Starting salaries for MBAs working on Wall Street are now in excess of $200,000, over three times the earnings of the student in our example, and will likely grow at a much faster rate than 4% a year. As a result, I don’t expect that many of you reading this blog from your desk at Goldman Sachs will likely volunteer to swap positions with our hypothetical $65k a year borrower, no matter how large your student loan debt or how attractive the economics of the REPAYE plan.
And for those borrowers who do qualify for participation in REPAYE or another IBRP, the amount of any loan forgiveness at the end of the program will under current law constitute taxable income, leaving the borrower with a large and perhaps unexpected incremental tax bill upon cancellation of the loan. In our example, the amount of tax due on the $200,000 of loan forgiveness under the REPAYE plan will be around $70,000 (at current tax rates), payable at the end of the 25-year period. The WSJ authors refer to this as a “tax bomb” and I guess it is, sort of. No one likes to pay taxes of course, and this is particularly true if the tax bill was unexpected or unplanned for, but paying $70,000 in taxes is a whole lot better than having to pay off the full $200,000 balance of the loan, even 25-years from now.
Incorporating that final year tax bill into our analysis, the total amount paid to the federal government by our hypothetical REPAYE participant was about $255,000 over 25 years. This is somewhat more in nominal (non-inflation adjusted) terms than the amount paid by those borrowers who amortized their loans in full over 10 years ($226,000) but less than the amount paid by those who amortized their loans in full over 20-years ($292,000). But when we are talking about payments made over long periods of time, like 25 years, we really need to look at real (inflation-adjusted) numbers, not just nominal ones. And when we do this, the REPAYE plan economics look even more compelling for those borrowers who qualify.
Using a growth annuity calculator, we can determine just how good a deal the REPAYE plan is for qualified borrowers relative to those who must repay their student loans in full over shorter amortization periods. The present value of the loans made to our 10 and 20-year full-amortization borrowers, discounted at the stated interest rate of 6%, equals the actual amount of the loans made to them, $150,000 at the time of borrowing and $170,000 at graduation. (This is tautologically true, of course, because we set the discount rate equal to the rate of interest and assumed zero loss from default.) For our hypothetical REPAYE borrower, however, the PV of the payments required of him is equal to only about 50% of the amount actually lent, or 60% if we also include as a loan payment the present value of the tax paid in year 25. At least this is the answer if the borrower’s annual earnings (and mandatory payments) grow at 4% a year, as we have assumed. But how fast would the borrower’s income have to grow in order for the PV of his payments under the REPAYE program to equal the full amount he borrowed? The answer seems to be an annual growth rate of about 9%, which is quite an aggressive assumption for 25 years of earnings growth.
My bottom line? The REPAYE plan seems to be a very good deal for the qualified borrowers and a very bad deal for the lender, at least on the terms outlined here.
Does this mean that income-based student loan repayment programs like REPAYE are necessarily a bad thing from a public policy perspective? No I don’t think so. I for one am attracted to the social “insurance” aspects of IBRPs, which create a financial safety net of sorts for those to whom life deals a bad set of cards. It is also possible that in the absence of IBRPs we would have even higher student loan default and delinquency rates that we do now, in which case even partial repayments under the IBRPs may be better than no payments at all.
I must say however that I am somewhat troubled by the perverse incentives of IBRPs, and subsidized student loan programs more generally, which seem to encourage some (many?) students to make financially unsound investments in expensive and non-commercial university programs and which almost certainly incentivize universities to offer and aggressively promote them. I am also troubled by the optics of some of these loan repayment programs, which do not appear to generate much in the way of public benefits (unlike loan forgiveness targeted to rural doctors for example). And I am concerned that university student loan subsidies (although perhaps not IBRPs specifically) may in fact be even more regressive than we think.
But we do have a big and growing student loan debt problem in this country and at some point we are going to have to agree what if anything we will do about it. Aggressively expanding IBRPs does not feel to me like a winner, politically or as a matter of public policy, but these plans may nevertheless have an important continuing role to play. And they may be preferable to some of the other more radical (and expensive) proposals being floated about in Washington and on Twitter.
I don’t expect that we will figure this all out any time soon, so you should expect more posts on this topic in the months and years to come.
Links:
Why Student Debt Keeps Growing—Even When Borrowers Keep Paying. WSJ 12.31.2021