Disclaimer: From discussions that I have had on this subject in the past, I realize that this is a controversial topic. I have never been one to shy away from discussion on touchy subjects whether ethical or financial in nature. This post will be about the financial side of the decision that I have made, but I can always write about the ethical side in the future if there is interest.
This is a subject that I have spent a very long time learning about, pondering, and crunching numbers on. No matter how many times I revisit the topic, I come to the same logical conclusion. For my situation, it is financially in my best interest to seek student loan forgiveness. As much as the thought of watching the balance of my student loans grow over the next twenty years sickens me, I know that it is in my best interest based on the calculations that I have performed. You may be wondering, how will the balance grow if you are making payments on the loans each month? The answer is that my minimum payment, based on the Pay As You Earn plan (that I have determined is the best choice for me), is not enough to cover the interest that is accruing each month. Although this is the path that I am choosing, there are a number of factors to consider in your own situation about what is the best option. Some of these include:
- Is working at a nonprofit an option for you in order to seek Public Service Loan Forgiveness*? (The best option for most if this is plausible)
- Are you able to be responsible with money that you have left over from choosing to have a lower student loan payment? (If you spend the extra money, from choosing an income based repayment plan, on unimportant things, then it is probably better to go with standard repayment)
- What will be your estimated adjusted gross income? (this is important to determine what your income based payment amount would be)
- Do you believe that your income will increase significantly over the next 20 years? (As your income increases, so does your income based payment)
- What are the interest rates on your loans? (With low interest rates, you may be better off investing the extra money than paying off the loan early)
- What will the balance on your loans be at the end of 20 years? (Based on the current tax laws, the amount forgiven at the end of the 20 year period will count as “unearned income” and lead to a significant tax bill)
- Which income based repayment plan would be best for you if you choose to go that route? (Check out the student aid website if you have no idea about this)
* Public Service Loan Forgiveness does not require taxes to be paid on the forgiven loan amount, in addition to having the loan forgiven 10 years earlier. Obviously a very good option if possible.
As a travel PT, I consider my situation to be somewhat unique in the loan repayment regard. Since part of my pay is untaxed, for living expenses while away at an assignment, my adjusted gross income (AGI) is less. I have also been contributing a significant amount to my 401k which further reduces my AGI. Both of these things combined, give me a somewhat low AGI. This makes my student loan payment low while also allowing me to save a significant amount of money. So I was then faced with the decision to either pay the minimum and invest the rest, or pay extra on my loans and pay them off as soon as possible. This is where the calculations came into play and helped me make the decision. Of course all of the numbers I used are estimates because there is no way to know what my exact pay will be in the future.
To give a little context without going too in depth, I currently owe just below $100,000 after accumulated interest while in school. My average weighted interest rate is a little over 6%. I had no debt from undergrad and lived at home during PT school in order to save on living expenses. For the most part, I lived as cheaply as I could, so the figure above is mostly from tuition, books, and food. Based on my estimates, if I put all of the money that I possibly could into paying off my loans quickly, I would be able to achieve that goal in around two years if everything went according to plan. This would lead to total payments of about $103,000. On the other hand, I could make minimum, income based, payments on the loans for 20 years, and then have the balance of the loans forgiven. The forgiven balance will count as “unearned income” and will be taxed. This means a big tax bill at the end of the 20 year period. For my calculations, I assume a 30% tax rate on the amount forgiven. The actual rate is unable to be determined because tax rates will be different at that time, and I am unsure of exactly what my income will be then, but I believe that 30% is a conservative estimate.
Using the studentloans.gov repayment estimator, it is estimated that over the 20 year period, making the minimum payments on the Pay As You Earn plan, I will pay about $88,000 and be left with a balance of about $126,000 to be forgiven. At first this seems like a much worse option but keep in mind that this is 20 years in the future. Based on an average 3%/year inflation rate, $103,000 is worth more today than $126,000 will be 18 years from today. Let’s look at the calculations to determine the total paid in this scenario.
$37,800 (tax bill from $126,000 forgiven) + $88,000 (amount paid in minimum payments over a 20 year period) = $125,800 paid in total at the end of 20 years
This means that I could pay about $103,000 over two years’ time, or I could pay a total of $125,800 over a 20 year period. In the 18 year period between the two estimates, it would only take an approximate 1.1% annualized interest rate to grow $103,000 to $125,500. If I am able to earn anything above a 1.1% interest rate on my money in that 18 year period through investments, then it is in my best interest to wait the 20 years and pay the tax bill at the end while making minimum payments along the way. I am confident that, with the asset allocation that I have chosen, I will earn a much better return than 1.1% over an 18 year period and therefore will be better off investing my money instead of paying off my loans early.
For the sake of comparison, if I were to choose the standard 10 year repayment plan, I would pay a total of $129,000 over a 10 year period. This is clearly worse than both of the options discussed above.
Now let’s consider another factor. Imagine that two years from today I pass away due to some unfortunate event. In the first scenario, I have my student loans paid off in full, but nothing to leave to my family. In the second scenario, I have paid very little toward my loans, but have somewhere around $100,000 in retirement and investment accounts. Since student loans are discharged upon death, I will leave my family with $100,000 and the loans won’t matter anymore. In this way, the second scenario can be viewed as a life insurance policy of sorts. Although the chance of death is much lower for younger people, you never know what may happen in life and the second scenario is clearly better in this regard.
But wait, there’s more. There is also a tax deduction based on the amount of interest you pay on your student loans up to $2,500 per year, even if you don’t itemize your return. This deduction is phased out if your AGI is above $80,000, but I don’t think that will ever happen for me based on 401k contributions reducing my AGI. You do not receive that full $2,500 back on your taxes, but will receive some percentage of it based on your income, likely somewhere in the neighborhood of 20%-25%. That means somewhere around $600 being returned to you each year on your taxes. $600 x 20 years = $12,000. In addition to the deduction, there has been legislation proposed to no longer have the forgiven loan balance count as unearned income, which would make loan forgiveness a much better option. There is no way to know if this will ever go through, but I would imagine there is at least a small chance over the next 20 years.