The Obama administration announced today that its redesigned Income-Based Repayment (IBR) regulations for federal student loans are now final. The plan, called Pay-As-You-Earn, is meant to help struggling borrowers repay their loans, but according to the Federal Education Budget Project report, Safety Net or Windfall? Examining Changes to Income-Based Repayment for Federal Student Loans, it also will provide substantial benefits to borrowers earning high incomes.
Ed Money Watch has published several posts detailing that finding and recommending changes to the policy that would prevent high-income earners from receiving a windfall while preserving the safety-net function of IBR for struggling borrowers. Nevertheless, the regulations that the U.S. Department of Education finalized today make no attempt to address this issue.
To better illustrate exactly how IBR will now provide significant benefits to higher income earners, below is a narrated micro-simulation for one hypothetical borrower.
It explains how different repayment plans affect the borrower, including:
- the original IBR repayment plan (“Old IBR”), signed into law in 2007, which caps a borrower’s monthly payments at 15 percent of his income minus cost-of-living exemption, and forgives all outstanding debt after 25 years;
- the consolidation plan that allows borrowers to pay over extended terms to reduce their monthly payments but requires that they fully repay their loans;
- and the “New IBR,” the plan that the Obama administration finalized today, which limits a borrower’s monthly payments to 10 percent of his income minus a cost-of-living exemption and forgives unpaid debt after 20 years of payments.
The narrative and accompanying table demonstrate that a hypothetical borrower – in this case a law school graduate earning more than $160,000 20 years into his career – will reap a massive windfall under the New IBR compared with the Old IBR. And it is obvious from his very first payment that New IBR delivers a very large subsidy compared to any other repayment plan available to him. As is shown below, the borrower in this example faces no downside or financial risk in maxing out his federal student loans and repaying through the New IBR while earning a six-figure income for much of his repayment term.
Robert’s Law School Loans: Old IBR
Robert attended California Western School of Law a few years after earning a bachelor’s degree from UC-Riverside in California. He borrowed $5,000 in federal student loans to pay for his undergraduate studies and made large prepayments on the loans when he worked at a law firm so that he would enter law school without any debt from his undergraduate studies.
U.S. News & World Reportdoes not publish a ranking for California Western School of Law, which puts it in the bottom fourth of all law schools.[i] The school lists an annual cost of attendance just under $68,000 and notes that the average starting salary for an employed graduate in a private practice is $62,000.[ii] The federal student loan program allows students enrolled in graduate and professional programs to borrow up to the full cost of attendance as determined by the school itself, with no aggregate limit. Although Robert could borrow nearly the full $68,000 each year he attends the school, he borrows only $35,500 a year for each of his three years because he has some other financial resources and plans to live frugally while in school. That means Robert graduates with $121,974 in federal student loan debt from law school alone with an interest rate of 7.375 percent.[iii]
Following graduation, he quickly finds a job in a small private practice with a starting salary of $65,000 (AGI $58,500). That is a little over the average starting salary for graduates from his school, but Robert was an above-average student.
Robert has a few choices to start repaying his $121,974 in federal student loans. He could pay $842 a month under fixed-rate consolidation with a 30-year repayment schedule, $750 for the first two years of repayment under graduated consolidation with a 30-year repayment term (payments will increase every two years), or $522 per month under Old IBR with loan forgiveness after 25 years if he has any outstanding balance. Robert chooses to enroll in IBR because it provides him with the lowest monthly payment and it offers loan forgiveness after 25 years, which is five years earlier than he would repay under the consolidation options.
In his third year with the firm, he gets a small raise, but in year five he takes a new job with a starting salary of $80,000 (AGI $68,000). That year he also is paid $20,000 for some onetime consulting work. That year, his monthly payment under IBR jumps to $831. That is the first year in which his payment under graduated consolidation would have been lower ($788) than his IBR payment, had he chosen that option initially. But Robert knows that his income will be lower next year without the contract work and IBR will again provide him with the lowest possible monthly payment, so he stays in IBR.
Robert also no longer has the option to lower his monthly payment by opting into the fixed-rate consolidation repayment plan; he is trapped in IBR.[iv] In fact, Robert will not gain a lower monthly payment by switching to consolidation until his 11th year of repayment, but opting into consolidation at that point means he will have a new consolidation loan with a new 30-year term. Combined with the time he repaid through IBR, his total repayment term would be 41 years with total payments of $416,439 (which is $74,346 in IBR plus $342,093 in consolidation). Furthermore, leaving IBR seems like a bad choice for Robert because he would qualify for loan forgiveness by his 25th year if he remains in IBR, rather than make payments for 41 years. Thus, even though IBR does not provide him with the lowest monthly payments, the lower payments he could make under consolidation provide him with no financial advantage.
Over the next several years, Robert does well at the new firm and gets a series of salary increases. He gets married in his eighth year of repayment, but files his taxes separately from his wife so that their combined income is not used to calculate his payments under IBR. (Robert’s wife has no student loans and earns a salary of $75,000.) By his 10th year of repayment he is earning $93,589 (AGI $79,550), and that year his first child is born. Robert continues to file his federal income taxes separately from his wife, but claims his child as a dependent on his return, thereby increasing the cost-of-living exemption that is factored into his student loan payment under IBR.[v] In year 10 of his repayment, he pays $639 per month under IBR.
In his 11th repayment year, Robert takes a new job with a salary of $120,000 and collects a signing bonus of $20,000 for a combined income of $140,000. Based on his new AGI of $133,000 that year, his monthly payment spikes to $1,298 from $639 the previous year. Had Robert chosen fixed-rate consolidation initially, his payment would be $842 at this point, or $848 under graduated consolidation.
Robert makes his first principal payment on his loans in his 15th year of repayment, having at that point paid off all of the interest he accrued when he was making lower monthly payments in the first 10 years of his repayment. Now that his salary is $134,984 (AGI $114,736), his monthly payment under IBR is $1,032, which means he will pay off his loan at a rapid pace as his income rises steadily each year by 4 percent. In year 20 when he’s earning a salary of $164,228 (AGI $156,017), his IBR payments are capped at $1,440 a month, the 10-year standard repayment rate based on his original loan balance. Because of that cap, he does not quite pay off his loan by his 25th year of repayment even though that year he is earning $199,809 (AGI $189,818). Robert still owes $22,867, but he has paid for 25 years so that amount is forgiven.
In total, Robert pays $297,766 in principal and interest over those 25 years. He would have paid slightly more under fixed-rate consolidation ($303,280), spread out evenly over 30 years, and he would have paid much smaller monthly payments in his later years of repayment than under IBR. But IBR was a good choice in that he was able to lower his monthly payments in his first three years of repayment when he was just starting his law career in exchange for having to make higher payments later on when his income was high—and he was assured of not having to repay past 25 years due to loan forgiveness.
Robert’s Law School Loans: New IBR
Under New IBR, Robert receives a significant windfall benefit compared with Old IBR and any other repayment option available to him. Even though Robert is earning what many would consider a good income in his early years of repayment, New IBR cuts his payments by about $175 compared with Old IBR. When his income is higher, the reduction is even greater. For example, when he earns $100,000 (AGI $85,000) in his fifth year of repayment, New IBR allows him to pay $277 less per month than he would under the Old IBR plan. The more his income goes up, the more New IBR reduces his payment compared to Old IBR.
Lower monthly payments cause Robert’s loans to negatively amortize at a rapid rate. He is paying off less than half of the interest his loan accrues each month in his first four years under New IBR, such that by the end of his fifth year in repayment his balance has ballooned to $143,501 on an initial balance of $121,974. At the end of year 10, Robert’s loan balance will reach $162,366. Yet during this time, Robert has been earning what many would consider a high salary and could have afforded higher payments—but Robert has little financial incentive to make higher payments on his loans than is required. Between years five and 10 of his repayment plan, his salary averages more than $88,000. Even so, the ballooning loan balance is not of any concern to Robert, nor should it be. With loan forgiveness after 20 years of payments, unpaid interest is of little consequence to him.
As Robert goes on to earn well over $100,000 annually after his 10th year of repayment, New IBR effectively allows Robert to forgo making a single payment on the principal balance of his loan. After his 20th year of repayment, he has paid a total of $141,350 on his loans but still has an outstanding balance of $160,536–all of his original principal balance and $38,562 in accrued unpaid interest. After 20 years of payments, that outstanding balance is forgiven when Robert is earning a salary of $164,228 (AGI $156,017) and has one child. His wife is now earning $90,000 a year. Robert and his wife are by most definitions a high-income household. In today’s dollars, their combined household income would be equivalent to $155,000.[vi] Furthermore, Robert goes on to earn a significantly higher income after his loans are forgiven, and making further payments would not have been a financial strain.
By comparison, had Robert chosen the fixed-rate consolidation he would have paid $303,280 over 30 years. In fact, even if Robert had repaid his loans under the standard 10-year repayment plan, he would have paid more in total ($172,789) than under New IBR.
Recall that Robert chose to pay off $5,000 in federal loans from his undergraduate studies when he was working at a law firm before he attended law school. While that seems like a prudent financial decision, under New IBR, Robert would have been better off saving that money and making only the minimum monthly payment instead. That is because his loans from his undergraduate studies would have been forgiven when his debt from law school was forgiven, and even though he enters IBR with a higher loan balance, he does not pay any more monthly or in total under New IBR than if he had paid the loans off prior to entering law school.
Of course, the decision for Robert to choose New IBR was an easy one. Consolidation requires that he repay his loan fully in 30 years, while IBR forgives his loan after 20 years—and it offers him the lowest monthly payments in every year until he reaches his 17th year of repayment, at which point he is only three years away from having his loans forgiven. For those reasons, the law school that Robert attended is likely to advise all of its students to borrow to pay for school—even if they have savings or other personal assets to put toward tuition—and enroll in IBR to repay.
[iii]Average indebtedness is closer to $150,000 for graduates of Cal Western. See Ryan Lytle, “10 Law Schools that Lead to the Most Debt,” U.S. News & World Report, 22 March 2012, http://www.usnews.com/education/best-graduate-schools/the-short-list-grad-school/articles/2012/03/22/10-law-schools-that-lead-to-the-most-debt. Robert paid off his undergraduate debt before enrolling in law school. To pay for law school, he borrows $20,500 in Unsubsidized Stafford loans (the annual maximum for graduate students) at a 6.8% interest rate each year of school. He borrows an additional $15,000 a year in Grad PLUS loans for each of the three years at a 7.9 percent rate. All of his loans accrue interest while he is in school. When he leaves school after three years of enrollment, he therefore has a principal and interest balance of $121,974 with a weighted average interest rate of 7.375 percent under the consolidation plan. That interest rate is used for the IBR calculations throughout this example.
[iv]His original loan balance of $121,974 after four years in IBR is now $132,754 because he has been making payments that are too low to pay off the interest that accrues monthly. If he were to switch into consolidation at this point he would have a new loan of that amount with a new 30-year term, making his monthly payments $916, higher than if he remains in IBR, and much higher than if he had chosen consolidation when he first began repayment.
[v] Note that a borrower repaying through IBR need not claim a child as a dependent on his or her tax return in order to have the child included in his or her household size under the IBR payment calculation. The borrower must simply designate the child as a dependent on the IBR application annually, regardless of who claims the child as dependent for purposes of federal income taxes. The New America Foundation paper incorrectly asserts that the two are one in the same when they are not. This error does not affect the findings in the paper or this example. The authors regret the error.
[vi]This figure is a present value calculation over 20 years with a discount rate of 2.5 percent.