I start veterinary school this fall, and I am planning on using IBR to pay back my veterinary school loans (~200k+) over 20 years.
I also have about $7000 in debt from my undergraduate loans. I just graduated so now the interest is starting to accumulate.
Should I (or is it even possible) to use IBR for both my undergraduate and veterinary school loans? Or should I just fully pay off my undergraduate loan right now? I have just about $7000 in my bank account from working a part time job.
Thanks for the help
Stringing out your loans via IBR is not a wise long-term financial strategy if you intend to make significant income in the future, which means that you will pay off your loans anyway (which I imagine you will). I am an attorney that graduated with $150,000 in student loans and weighed the IBR/pay-them-off debate for eight months before I realized IBR/PAYE would cost significantly more money than just paying them off. So here's a (slightly edited) post I wrote several months ago involving math concerning $150,000 in student loans:
First realize that you will be taxed on any amount forgiven when you are done after 20 years. So if you are forgiven $250,000 (which is possible if you make minimum payments), 38% of that is $95,000 in tax liability.
Second, while you are enrolled in PAYE/IBR, the government will only reimburse you for interest on your Subsidized Stafford loans. For me, these are only about 10% of my loans. More importantly, the rest of unpaid interest after three years capitalizes up to 110% of the loan (see here:
http://www.ibrinfo.org/what.vp.html). Thus, by not being aggressive early on (and only paying $221 per month), my loan would balloon to over $160,000 easily, despite the forgiveness on my Subsidized Stafford Loans.
Side note: right now, I am enrolled in IBR even though I'm making huge payments. This means for the next three years, I'm barely putting anything towards my Stafford Loans, covering about $10 more than the monthly interest on all other loans (so they don't capitalize), and putting everything else towards my highest interest loans.Third, PAYE estimates my monthly payment to be $221, meaning there would be almost $600 in interest being added each month. What happens if I get a job paying $100,000 per year in the near future? Now my payment shoots up to $604 and I'm still not gaining ground on the interest. I'll get to the math later on why this is bad.
Fourth, investing instead of paying off debt makes sense only when you can get returns in the market that exceed the interest rates on your loans. I'm a believer in passive investing, which returns 7-8% over the long haul...but what if the economy takes a hit in year 20 when your tax liability is due? Even worse, do you really want to have to guess and switch all your investments to bond index funds a couple years before your tax liability is due and perhaps miss out on huge returns in a bull market? This makes PAYE/IBR a HUGE gamble to me.
And this leads me to my fifth and most important point: I can't risk this plan with the hope that the government will amend the tax bill. This is for two reasons. First, the entire program becomes insolvent if you remove the tax burden. This would lead to even more increased tuition and outcries from a younger generation. Second, and more importantly, the present tax code accounts for people who really can't afford the tax liability. The IRS fact sheet on forgiven debt (
http://www.irs.gov/pub/irs-pdf/p4681.pdf) provides, basically, that you are only accountable for forgiven debt to the extent that it exceeds your assets. So say the average Joe is on PAYE and paid for 20 years, thus allowing his loan to balloon to $250,000. Fortunately, because he's an average Joe and not a mustachian, all he has is a $150,000 house and $100,000 in his 401k. That means that his assets are equal to his forgiven debts and he therefore has no tax liability.
Of course, there are a lot of variations to this. But the point is that (1) the tax code already accounts for people who can't pay the tax liability and (2) the "tax bomb" problem people say will happen in 20 years isn't as bad as people think.
In Mustachian terms, however, this tax break wouldn't apply to you because you've been socking away money in a traditional brokerage account for 20 years (i.e., your assets would significantly exceed your forgiven debt). Thus, you would probably be the exception in having to actually pay the full tax liability.
Which leads me to the math.
The government estimates a 5% raise, which I think is fair. They estimate I'll pay $102,000 principal over the life of loan and have $249,000 forgiven.
Since I'll be stocking away money, my assets will dramatically exceed my liabilities, so I'll have to pay the full tax liability. Assuming a 38% tax bracket (which is certain given that the forgiven debt alone is $249,000), that comes to $94,620. So all in all, I'll have paid $196,620 towards the loan, or around the same amount if I just paid this off in 8 years.
But let's go even further. Let's look at everything else.
First, deductions lost because you had to file separately (this isn't negotiable for me...my GF makes substantially more than I do, and if I eventually made $100,000 per year, our incomes together would put me at a $1104 payment, or enough to pay the loan before it's forgiven).
Student loan interest deduction = $2500. Assuming 20 years of this and 25% tax bracket, you've missed out on either a deduction to your tax liability every paycheck or a $625 refund check from the feds every year.
Dependent care credit = $3000 per year per kid. Assume two kids (my plan) so $6,000 per year. Now you've missed out a $6,000 deduction on your taxable income or a $1,500 refund every year.
Married credit = $14,200 per year (compared to $6,200, which only one of you or your spouse can claim if you file separately). That's an $8,000 difference in taxable income per year, or $2,000 in cash.
There are more than these three, but these are the three biggest ones. And putting your spouse in the equation (since he or she is filing separately as well), you're looking at $25,000 in lost deductions per year for 20 years ($500,000!!!). Again, assume a 25% tax bracket, and we're talking $125,000 in income taken out of your paychecks or tax refunds.
So now we're at your $196,020 in paying towards the loan plus $125,000 in lost deductions.
I feel like Billy Mays here--BUT WAIT, THERE'S MORE. Let's go back to the tax liability. Assume you've been throwing what would have been your student loans into an investment account, and now you need to cover your tax liability. Now you actually need to withdraw 16% more than your tax liability to cover capital gains, meaning you'd actually need to withdraw $111,383 to cover the tax liability.
Now we are at $102,000 principal payments + $125,000 in lost deductions + $111,383 to cover tax liability. Total cost is $338,383.
And by this 20th year, you've just substantially depleted your investment account when you are 47. You also haven't been able to contribute to a Roth IRA (since you can't when filing separately).
And I'll end on this: no matter what you guys are saying, IBR and PAYE will make you a slave to your loans more than paying would. Every financial decision you make will revolve around your payment and your tax liability for TWENTY YEARS. You also have no idea what will happen in terms of income--what if you've let interest balloon for ten years, but then you become a member of an incredibly lucrative LLC that nets you $500,000 income per year? Now you might not have a financial hardship and your loan would capitalize. Sure, you can pay off your loans with that much income, but my word, that will be WAY MORE than if you had just taken care of it.
Put most simply, IBR and PAYE are huge gambles due to the unknown tax liability, having to file separately, lost deductions, inability to forecast income, and having to pay capital gains when you pay the tax liability. In the meantime, you CAN start making dents on your loans NOW if you put your mind to it and take control of the situation. If I pay my loans off in 8 years and maintain my lifestyle afterwards, using MMM's chart, I'll be about 7-10 years away from retirement. And that's way more optimal to me than risking everything on IBR/PAYE.
Now, with all of that said, here's my advice...I had a blast in undergrad and law school, but damn do I regret living off my loans like the party would never end. Please don't make the same mistake as me.
Live as frugally as you possibly can. Work part time as much as you can. Limit the amount of loans you take out. Do everything you can to earn scholarships. Get the best possible grades you can.
And when you graduate, obliterate your loans.