Interesting discussion ReadySetMillionaire & Tank_Esq
I have a similar situation student debt wise and am curious how other people are handling the debt, and what MMM thinks of dealing with this. I tend to agree with Tank_Esq. I think ReadySetMillionare is right that the Income driven plans are a gamble, but they could pay off.
Here are a few points I don't think you have discussed yet regarding IBR and PAYE.
If your loans just went into repayment, you get 3yrs of IBR or PAYE where the government will pay the leftover interest on the loans after you make your 10-15% of income payment. No interest accrues during this time. If you have extra income you could pay the minimum each month, have the government pay the rest of the interest for the month, and then make an additional payment directly to principal.
After three years, in either plan, as long as you maintain a financial hardship, (which with a loan of $150,000, is earning something under around $100,000,) interest accrued on the loan does not compound. The unpaid interest just sits in a little side pile, that will be forgiven or paid off with all the money and compounding interest that you earned on the borrowed money that you did not put back in the loan.
The situation will vary from person to person, but if you invest the difference your standard 10yr loan payment, and the 20 year PAYE each month, you should have around the same amount of money in your investment account and your debt account in 5-8 years. That gives you 12-15 years of two accounts, investment with interest compounding, and debt with simple interest.
20 yrs is up and if nothing changes, you do get a nasty tax bill on the 200,000 plus loan and interest you have accrued, but even if this is close to 40%, you can pay it out of your investment account no problem.
Luckily Elizabeth Warren is working on non-taxable forgiveness for us--I believe she already put forth bill suggesting this. There is a lot of talk about refinancing public loans too. The government would have a hard time changing the rules on student loan forgiveness, as this would just bankrupt millions of people.
Obama did change the rules for PAYE for almost everyone. ReadySetMillionaire, you and I will be allowed into the PAYE system in October of this year. When you switch plans, the years on your loan do not reset. If you already five yrs in, you only have 15 more to go for forgiveness.
Lastly, check out this link. It basically shows how the current income based repayment system is a cash cow for Lawyer and future high earner types. It has a nice spreadsheet to accompany.
http://newamerica.net/publications/policy/safety_net_or_windfall
Look forward to comments and rebuttals...
Interesting post, and I'll rebuttal point by point.
First, I guess I will qualify for PAYE this October. Yay me I guess.
Second, regarding forgiven interest, 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 towardsmy highest interest loans.Third, my PAYE estimated 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? 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, your post assumes 7% returns in the market. I'm a believer in passive investing over the long haul, so that's fair. But what if the economy takes a hit in year 20 when your tax liability is due? 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). 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 do 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.
[Exits stage and waits for rebuttal...good discussion!].