Our op-ed in the Washington Post today uses a hypothetical student loan borrower to illustrate one of the reasons why the Obama administration revised the costs of the Income-Based Repayment (IBR) program up by $21.8 billion. Politico reported the revision earlier this month, which was included in the president’s budget. Our op-ed provides some important context to the Politico article. It illustrates why graduates students — even those earning good incomes — are the biggest winners under the IBR program and likely account for a lot of the extra $21.8 billion in costs. We provide more detail about the example we used in the op-ed below.
We profiled a hypothetical law school graduate, Robert, who graduates with $150,000 in debt (the average for a law school student with loans) at a 6% interest rate. Robert lands a job making $70,000 a year, with his wife making $80,000. In his first year of repayment under IBR, his monthly payment will be $0, because IBR uses his previous year’s income (while he was in school), to calculate his payment.
In his second year of repayment, his monthly payment will be $238 on what is now a $159,000 loan, thanks to a year’s worth of interest. Under IBR, borrowers make payments equal to 10 percent of their “discretionary incomes” and have any debt remaining after 20 years forgiven. Before the Obama administration changed the program in 2010 and 2012, those figures were 15 percent of discretionary income and 25 years of payments before loan forgiveness.
If Robert’s $238 monthly payment seems too low to be 10 percent of his income, that’s because it is. This is one of least-understood benefits of IBR.
First, Robert can exclude his wife’s income from the calculation by filing separate income taxes. And as we show later, he can still claim his wife and child in his household size when calculating his exemption under IBR, no matter how he files his taxes.
Second, Robert’s payment is not calculated off of his total income, but rather his Adjusted Gross Income, $59,500, which is lower because pre-tax expenses are automatically excluded. Even though Robert earns $70,000, his $3,000 in health insurance premiums, $4,000 in retirement savings, and his $3,500 contribution to a dependent care account are excluded from that figure, resulting in an Adjusted Gross Income of $59,500. (Borrowers who don’t file separate income taxes can also deduct their student loan interest payments from their total incomes when calculating Adjusted Gross Incomes.)
After that, he subtracts another $30,900, which is the exemption he receives under IBR for himself, his wife, and his child as a basic cost-of-living allowance. Therefore, the 10 percent of income, in this case, is actually calculated off of only a $28,600 income.
In reality, Robert isn’t making loan payments equal to 10 percent of his total household income; he’s paying only 1.9 percent. He won’t make a dent in his student loan paying at that rate. That is true even though Robert earns an annual raise of 4 percent, and a promotion in his 10th year of repayment brings his salary to $150,000 that year. By his 20th year of repayment he earns $222,000 per year.
At that point, which is when he qualifies for loan forgiveness under IBR, Robert hasn’t even reduced the loan’s principal. He’s paid only interest for 20 years, and not even all of it. He still has a $166,000 balance at that point, more than he borrowed, which the government then forgives. Note that the forgiven debt would, however, be treated as taxable income, but the Obama administration wants that rule repealed.
Before the Obama administration made changes to the IBR program, Robert would have fully repaid the loan. That is because he pays more per month and for five more years. His payments would total $330,000 in principal and interest.
Our op-ed does not mention the Public Service Loan Forgiveness benefit available to anyone working in a non-profit or government job. That benefit works just like scenario we described above except that loan forgiveness occurs after only 10 years of payments and the forgiven debt is not taxable. Had Robert qualified for that benefit, he would have $201,734 forgiven after making total payments of only $38,266.
The calculator we used for this estimate can be downloaded here. It can be used to generate other scenarios by entering debt level, interest rate, borrower income and household size.
Alexander Holt co-authored this piece.
[Cross-posted at Ed Central]