This is for a friend. The scenario has so many variables, I'd love another set of eyes on the analysis.
Background:
Salary around $50k, federal government, with good potential growth prospects (could/should be $80k soon, but expected increases/promotions have been frozen/denied)
Living expenses relatively high - DC area, friend is very frugal but has to weigh frugality against career growth (eg turning down expensive lunch invites from oblivious superiors)
Student debt of $120k at an average of around 7%!!!
Here's the twist- currently, after 10 years of public service (need not be consecutive), entire student debt is assumed/forgiven by fed. Let's omit ethical considerations of accepting government aid. It's an open question whether this program can or will go away before the 10 years are up.
Right now, friend is repaying via "income based repayment" which chooses your payment to not exceed a certain amount of DISPOSIBLE income. At current salary, this minimum required payment does not even cover interest, so debt will be increasing unless additional payments are made.
There are many possible scenarios here:
1) just pay the debt as aggressively as possible-- likely pay it all off within 10 years. This means no debt forgiven, but avoids the risk of scenario 2:
2) pay minimum, don't get much salary growth, and something goes wrong (can't achieve 10 years in public service, or debt forgiveness program goes away). End up with many years of accumulated interest to pay off!
3) pay minimum, don't get much salay growth, but after 10 years debt is forgiven (ok scenario I'd think)
4) pay minimum, and for a few years principal balance increases. But over time, salary grows significantly, and income based payment rises and starts paying down loan. Loan is therefore paid off entirely/significantly before 10 year forgiveness. This is a pretty good scenario because income is high, but not as preferable as 5:
5) pay aggressively, salary growth high. Loan is paid off long before 10 year forgiveness kicks in. Minimizes Accumulated interest.
So the uncontrollable variables here are salary growth and whether/how much debt is ultimately forgiven. The controllable variable is how aggressively to pay down the loan.
Either option carries risk - the most conservative approach is to pay aggressively, but that mostly precludes the possible windfall of debt forgiveness. There's also probably a hybrid approach where you just cover the interest or something.
Thoughts?
Extremely complex financial planning question
Hey Dragoncar,
I have several thoughts that you didn't include:
1. Restructure the debt so that the interest isn't so bad - if your pal has a good credit history and assuming he hasn't been working for less than a year or two (with 120K I assume it has not been a lot longer either). This way perhaps he can escape the predicament you describe where his current minimum < interest payments. He could even try to "sweeten" the pot for the bank by extending the loan period or increasing payments slightly - I'm sure he can find online resources for how to knock down student debt. I don't know if he's in a "vulnerable" position but I assume that if Obama retains the Presidency, he'll be in a stronger position.
2. Find a job which will forgive/help pay down student debt - if he has good skills/contacts, it's always valuable.
3. Making a decision on what to do for 10 years based solely on student debt is a sad thing - I'd advise your friend to think about what he wants to do first.
4. Irrespective of my previous suggestions, I'd pay the interest only, because that is the extent of the "risk" we are talking about. Also, we did not discuss inflation and how it affects the loan (no data), but since US govt salaries get adjusted, the best thing to do is just pay the interest - if there is debt forgiveness in 10 years, your friend will regret paying even a single dollar of principal!
Just my 2 cents
Magnus
I have several thoughts that you didn't include:
1. Restructure the debt so that the interest isn't so bad - if your pal has a good credit history and assuming he hasn't been working for less than a year or two (with 120K I assume it has not been a lot longer either). This way perhaps he can escape the predicament you describe where his current minimum < interest payments. He could even try to "sweeten" the pot for the bank by extending the loan period or increasing payments slightly - I'm sure he can find online resources for how to knock down student debt. I don't know if he's in a "vulnerable" position but I assume that if Obama retains the Presidency, he'll be in a stronger position.
2. Find a job which will forgive/help pay down student debt - if he has good skills/contacts, it's always valuable.
3. Making a decision on what to do for 10 years based solely on student debt is a sad thing - I'd advise your friend to think about what he wants to do first.
4. Irrespective of my previous suggestions, I'd pay the interest only, because that is the extent of the "risk" we are talking about. Also, we did not discuss inflation and how it affects the loan (no data), but since US govt salaries get adjusted, the best thing to do is just pay the interest - if there is debt forgiveness in 10 years, your friend will regret paying even a single dollar of principal!
Just my 2 cents
Magnus
I think I would go with do one of the minimum pay scenarios, but save/invest all of the money that would have been used in the aggressive pay scenario in case the program disappears, although I think that is unlikely right now given the prominence of student loan debt in the news these days. If the debt forgiveness goes away, then you take all the saved money and throw it at the debt.
Advancement in pay grade is still pretty automatic in the government after a few years if you don't piss anyone off. But if he doesn't think he can stick it out, he'll need to rethink the scenarios.
Advancement in pay grade is still pretty automatic in the government after a few years if you don't piss anyone off. But if he doesn't think he can stick it out, he'll need to rethink the scenarios.
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jennypenny
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Is there any way to get the rate lower? (sorry, I don't know much about those loans)
I wouldn't be in any hurry to pay off a student loan right now. Even if the debt forgiveness program you referred to disappears, I wouldn't be surprised to see others take its place. It's such a hot issue.
On the other hand, a (petty) wrinkle which *might* make me consider paying off the loan--dating. If I met someone who was over $100K in the hole, making minimum payments, and hoping for the debt to be forgiven, I would consider walking away. Even if I stayed, I wouldn't legally marry someone in that situation. Sorry, just being honest.
I guess my answer depends on whether they're unattached and how important that is to them. If it's not an issue, keep the loan.
I wouldn't be in any hurry to pay off a student loan right now. Even if the debt forgiveness program you referred to disappears, I wouldn't be surprised to see others take its place. It's such a hot issue.
On the other hand, a (petty) wrinkle which *might* make me consider paying off the loan--dating. If I met someone who was over $100K in the hole, making minimum payments, and hoping for the debt to be forgiven, I would consider walking away. Even if I stayed, I wouldn't legally marry someone in that situation. Sorry, just being honest.
I guess my answer depends on whether they're unattached and how important that is to them. If it's not an issue, keep the loan.
A couple of points that might make the decision easier:
As I understand it (and I am no expert on these loans so consider the source), under an IBR, the government pays the remaining unpaid accrued interest on the subsidized loans for up to three consecutive years from the date the debtor begins repaying the loans under IBR.
In addition, unpaid interest is usually capitalized only if the debtor no longer has the "partial financial hardship" that qualified him for IBR to begin with or if he chooses to leave IBR.
So whether the agency forgiveness stays or not, it might make sense to stay with the IBR.
As I understand it (and I am no expert on these loans so consider the source), under an IBR, the government pays the remaining unpaid accrued interest on the subsidized loans for up to three consecutive years from the date the debtor begins repaying the loans under IBR.
In addition, unpaid interest is usually capitalized only if the debtor no longer has the "partial financial hardship" that qualified him for IBR to begin with or if he chooses to leave IBR.
So whether the agency forgiveness stays or not, it might make sense to stay with the IBR.
Doh, I just noticed options 1 and 5 are basically the same. Fwiw, my first order analysis would also be to make minimum payments. And invest the difference.
My friend is leaning towards a higher contribution level simply because the amount of debt is terrifying.
I am not aware of any way to restructure or reduce the interest rate. Any references would be great. Note that private restructuring may no longer qualify as student debt for foregiveness and tax purposes.
As far as I know, my friend is not considering changing careers based on the debt. The open question is how much to pay.
Also, after 25 years of repayment, the debt is forgiven regardless of service. So if you lose your job for 25 years, your payment is probably zero or close, and debt is forgiven. Not an option I'd personally pursue but it is a backstop.
Marriage does affect the repayment rate I believe (combined income), which would make it stupid to get maried with the debt.
There's another wrinkle involving school provided loan assistance, but that makes everything even more needlessly complicated. The repayment assistance has an income cap/phase out, and is subject to funds available to a California state university (budget woes). However, a higher required payment amount would mean more assistance while it lasted! Oh, and there's an asset test so you have to shelter additional savings in various safe havens. I think it's easier to Ignore this and assume income above the cap after a few years.
My friend is leaning towards a higher contribution level simply because the amount of debt is terrifying.
I am not aware of any way to restructure or reduce the interest rate. Any references would be great. Note that private restructuring may no longer qualify as student debt for foregiveness and tax purposes.
As far as I know, my friend is not considering changing careers based on the debt. The open question is how much to pay.
Also, after 25 years of repayment, the debt is forgiven regardless of service. So if you lose your job for 25 years, your payment is probably zero or close, and debt is forgiven. Not an option I'd personally pursue but it is a backstop.
Marriage does affect the repayment rate I believe (combined income), which would make it stupid to get maried with the debt.
There's another wrinkle involving school provided loan assistance, but that makes everything even more needlessly complicated. The repayment assistance has an income cap/phase out, and is subject to funds available to a California state university (budget woes). However, a higher required payment amount would mean more assistance while it lasted! Oh, and there's an asset test so you have to shelter additional savings in various safe havens. I think it's easier to Ignore this and assume income above the cap after a few years.
Ibr forgiveness is 25 years under the plan (maybe it changed, but as you mention, the terms tend to lock in hen you take out the loan, so NEW ibr may be 20 years but for friend, it's 25. This is also why the interest rates are terrible given the current fed rate)
Public service foregiveness is 10 years. This is almost any government job.
I didn't know this but good point that ibr interest does not compound. However the 3 year gov interest payment is only for subsidized loans, which (I'm not sure) I doubt we can count on.
My friend originally wanted a gov job due to perceived stability and reasonable hours. However, she hates the ridiculousness/drama/red tape, and has been working very long hours. It seems like a tough spot because it's hard to leave a punishing job when you have that debt hanging over your head, no time to job hunt or interview, and don't want to burn bridges unnecessarily (everyone tends to know everyone in DC).
So yes, it may help to factor the possibility of private sector. However, I'd guess that the private sector equivalent would pay enough to make the point moot. I think my friend can do much better, but there werent many choices graduating 2 years ago.
Anyways, it's enough to say that it boils down to personal preference. I just wanted to make sure there wasn't something I was missing. It seems like people are leaning toward low payments but no consensus.
It just seems like it's likely my friend will regret any decision. If she pays it off but stays in service 10 years, Doh I could have saved myself 100k! If she pays the minimum, but gets good salary growth, Doh I let all that interest accumulate the first few years! If she pays the minimum but doesn't get foregiveness... Doh now I have 200k in loans!
At least aggressive payment will give personal pride, but man I think it's dumb to miss out on a "bail out" when all the corporations got one!
Ps I don't personally think it was a good idea to get all that debt in the first place but that's neither ere not there.
Public service foregiveness is 10 years. This is almost any government job.
I didn't know this but good point that ibr interest does not compound. However the 3 year gov interest payment is only for subsidized loans, which (I'm not sure) I doubt we can count on.
My friend originally wanted a gov job due to perceived stability and reasonable hours. However, she hates the ridiculousness/drama/red tape, and has been working very long hours. It seems like a tough spot because it's hard to leave a punishing job when you have that debt hanging over your head, no time to job hunt or interview, and don't want to burn bridges unnecessarily (everyone tends to know everyone in DC).
So yes, it may help to factor the possibility of private sector. However, I'd guess that the private sector equivalent would pay enough to make the point moot. I think my friend can do much better, but there werent many choices graduating 2 years ago.
Anyways, it's enough to say that it boils down to personal preference. I just wanted to make sure there wasn't something I was missing. It seems like people are leaning toward low payments but no consensus.
It just seems like it's likely my friend will regret any decision. If she pays it off but stays in service 10 years, Doh I could have saved myself 100k! If she pays the minimum, but gets good salary growth, Doh I let all that interest accumulate the first few years! If she pays the minimum but doesn't get foregiveness... Doh now I have 200k in loans!
At least aggressive payment will give personal pride, but man I think it's dumb to miss out on a "bail out" when all the corporations got one!
Ps I don't personally think it was a good idea to get all that debt in the first place but that's neither ere not there.
You probably could (friend considered this option when looking for jobs).
Here are the deets on the program, btw: http://www.finaid.org/loans/publicservice.phtml
If you think about it though, even with a massive debt of 120k, 10 years of public service employment only works out to around 12k-23k of forgiveness per year (depending on whether you want to include interest). Private sector employment will often beat this benefit.
I've always considered employment in public service/non-profits to be equivalent to donating money by taking a lower salary than you would otherwise earn doing equivalent work in the private sector. Unfortunately, this "donation" of accepting a lower salary has not historically provided any tax benefits. Seems like a flaw in the charitable giving rules to me.
Here are the deets on the program, btw: http://www.finaid.org/loans/publicservice.phtml
If you think about it though, even with a massive debt of 120k, 10 years of public service employment only works out to around 12k-23k of forgiveness per year (depending on whether you want to include interest). Private sector employment will often beat this benefit.
I've always considered employment in public service/non-profits to be equivalent to donating money by taking a lower salary than you would otherwise earn doing equivalent work in the private sector. Unfortunately, this "donation" of accepting a lower salary has not historically provided any tax benefits. Seems like a flaw in the charitable giving rules to me.
If your ERE fund could pay your salary though (Basically donate to your 501c3, then pay yourself back via salary), you could give yourself some kind of cushy "job" (something significant enough to fall just short of actual fraud) and the debt forgiveness in 10 years rather than 20-25 would just be a bonus.
One scary thing about IBR I just noticed when looking through dragoncar's link is that the forgiveness will apparently be taxed as income at the time of forgiveness under current federal income tax rules. So if you start out with 100k-200k in loans, and the 7% interest accrues on it for 20-25 years with a low enough income to be making zero payments, you'd be looking at $500k - $1M of student loan debt. With the top income tax rate around 35% you'd be looking at around a $300k income tax bill during the year the loan is forgiven.
Apparently the public service forgiveness is not taxed as income though.
The whole thing is so nuts there's bound to be lots of loop-hole plugging when people in these extreme scenarios actually start to get in the newspaper.
One scary thing about IBR I just noticed when looking through dragoncar's link is that the forgiveness will apparently be taxed as income at the time of forgiveness under current federal income tax rules. So if you start out with 100k-200k in loans, and the 7% interest accrues on it for 20-25 years with a low enough income to be making zero payments, you'd be looking at $500k - $1M of student loan debt. With the top income tax rate around 35% you'd be looking at around a $300k income tax bill during the year the loan is forgiven.
Apparently the public service forgiveness is not taxed as income though.
The whole thing is so nuts there's bound to be lots of loop-hole plugging when people in these extreme scenarios actually start to get in the newspaper.
Sounds like she should also be looking for a different government job if she can. Or one of those other positions in that laundry list of occupations that qualify. I've known many people who have jumped from one agency to another and it seems like its easier to get a government job if you already have one.
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jacob
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Is it impossible to pay more than minimum? How about paying all the interest, that's $8400/year. At least that's treading water.
Also, is this a case of "I can live on $16000/year but $6000/year just doesn't sound comfortable?". In that case, the $6000/year budget could probably pay it off in less than a decade---probably around half.
So it's a weighing between the uncomfortableness of dealing with the spending side vs that of dealing with having a large debt hanging over the head given the frustrations of the job. From what I know about people, the latter is worse than the former---but that probably depends on individual levels of how importance independence is.
Or put it in other terms: You're in prison with a 10 year sentence. However, you could get out in five if you decide to spend it in another prison that sounds uncomfortable but will probably feel the same after about a year or so (hedonic adjustment). Which prison do you want to be in?
Or yet other terms: Debt forgiveness certainly sounds nice in terms of "getting away with it" (although I'm more of the old school of paying it back regardless of what the contract said), but realize that the cost is N extra years of one's life in an undesirable job. That's no longer a free lunch. That can be a costly lunch in terms of perspective. (Then again, I started ERE exactly because of my preference ... and that wasn't debt on my person ... that was due to potential mortgage debt. My preference is not the norm.)
Also, is this a case of "I can live on $16000/year but $6000/year just doesn't sound comfortable?". In that case, the $6000/year budget could probably pay it off in less than a decade---probably around half.
So it's a weighing between the uncomfortableness of dealing with the spending side vs that of dealing with having a large debt hanging over the head given the frustrations of the job. From what I know about people, the latter is worse than the former---but that probably depends on individual levels of how importance independence is.
Or put it in other terms: You're in prison with a 10 year sentence. However, you could get out in five if you decide to spend it in another prison that sounds uncomfortable but will probably feel the same after about a year or so (hedonic adjustment). Which prison do you want to be in?
Or yet other terms: Debt forgiveness certainly sounds nice in terms of "getting away with it" (although I'm more of the old school of paying it back regardless of what the contract said), but realize that the cost is N extra years of one's life in an undesirable job. That's no longer a free lunch. That can be a costly lunch in terms of perspective. (Then again, I started ERE exactly because of my preference ... and that wasn't debt on my person ... that was due to potential mortgage debt. My preference is not the norm.)
Unless that prison is Oz...then I take the 10 year prison.
I would pay the interest and get in the program. Once in the program that person is golden. As someone else stated, only people not in the program would be in danger of losing the program. Plus, it's almost guaranteed anyone in government will be promoted over the next 5 years, as half the government is going to be retiring. There are going to be massive holes to fill.
I would pay the interest and get in the program. Once in the program that person is golden. As someone else stated, only people not in the program would be in danger of losing the program. Plus, it's almost guaranteed anyone in government will be promoted over the next 5 years, as half the government is going to be retiring. There are going to be massive holes to fill.
What is currently happening to the unpaid interest in terms of it capitalizing seems to be a key factor here. Many people aren't aware that govt issued student loans can have some very funny things happen in terms of interest capitalizing-- very different than what one experiences with a private sector loan. Also people will often stick with the govt loan at a higher rate, rather than consolidate privately at a lower rate to gain the benefits of the wacky govt programs (I did this).
For example, I accumulated unpaid interest for 7 years on my student loans, but I never let it capitalize, thus I never paid interest on that unpaid interest (the govt got no compounding). When I got into a position to pay back the loan, I payed off the unpaid interest again without letting it capitalize.
Perhaps your friend could pay $2500/year in interest to optimize the tax deduction. The difference between $2500 and $8400 could be allowed to accumulate, so long as it does not capitalize. Your friend meanwhile would save this amount in a stable boring investment, so that the accumulating interest could be paid of lump sum if a job change happens, again to avoid that lump sum becoming principal. If the unpaid interest currently capitalizes, I agree with Jacob, pay the interest off yearly-- most of the programs allow you to pay more than the minimum.
As to the value of the forgiveness, I'd value it based on the principal and interest, and I'd remember that salaries are spoken of in pre-tax dollars, but loans are paid back post tax. So, forgiving $20k per year in loans, may be very similar to earning an additional $27-30k in salary.
Were I in your friends shoes, I would try to set aside the money I had available to pay on the loan. If the forgiveness works out, you get a huge benefit, if it doesn't, well at least you've already started digging your tunnel out of the debt prison.
For example, I accumulated unpaid interest for 7 years on my student loans, but I never let it capitalize, thus I never paid interest on that unpaid interest (the govt got no compounding). When I got into a position to pay back the loan, I payed off the unpaid interest again without letting it capitalize.
Perhaps your friend could pay $2500/year in interest to optimize the tax deduction. The difference between $2500 and $8400 could be allowed to accumulate, so long as it does not capitalize. Your friend meanwhile would save this amount in a stable boring investment, so that the accumulating interest could be paid of lump sum if a job change happens, again to avoid that lump sum becoming principal. If the unpaid interest currently capitalizes, I agree with Jacob, pay the interest off yearly-- most of the programs allow you to pay more than the minimum.
As to the value of the forgiveness, I'd value it based on the principal and interest, and I'd remember that salaries are spoken of in pre-tax dollars, but loans are paid back post tax. So, forgiving $20k per year in loans, may be very similar to earning an additional $27-30k in salary.
Were I in your friends shoes, I would try to set aside the money I had available to pay on the loan. If the forgiveness works out, you get a huge benefit, if it doesn't, well at least you've already started digging your tunnel out of the debt prison.