Consumer Comeback Blog

How NOT to repay student debt – a cautionary tale

A good friend of mine told me this story a few weeks ago, and I’ve asked his permission to share it here because it makes a great cautionary tale for prospective, current, and recently graduated students about student loan debt.

One of the biggest problems with student loans is that those who take them rarely understand the full consequences and responsibilities of repayment. How many 18 year old high school grads thoughtfully consider what they’ll owe in loan payments after graduation as a part of their college choice? Looking back at even my own decisions, if I fully understood what my monthly payments would be, I might have made some very different choices. I’m willing to bet there’s not a whole lot of graduates who finished with a brand new car’s worth of student debt (or more) who feel differently.

And while it is becoming ever more important that prospective students educate themselves on what they’re getting into with student loans, this advice does nothing for those who already have the debt and are now trying to pay it back. With costs of education at an all time high and job prospects for recent graduates at a low, paying back student debt is harder than its ever been.  But that fact doesn’t change the responsibility of paying it back, and if you can’t meet that responsibility, it can only get worse…

For the sake of anonymity, I didn’t use my friend’s real names. I’ll call them Tim and Ann:

Ann’s Law School Debt

Tim and Ann were married about 2 years ago. Tim runs a small business from his home, which he bought about 4 years ago. Ann finished law school about 3 years ago and got a job as an attorney right out of school. She is actually rather fortunate as new attorneys have had a tough time finding real work during this recession – a profession previously thought to be mostly “recession-proof”.

Both Tim and Ann make a comfortable living. Though despite having other offers, Ann took a government job and doesn’t make quite as much as she would have in the private sector.  So because her debt is so great, Ann’s student loan payments keep their lifestyle rather modest. You see, she finished law school with a little more than $180,000 of student loan debt. And because she consolidated her loans and was on the “income contingent” plan she paid around $700/month (based on her salary). But now that they are married, counting Tim’s income, her payments increased to more than $1,100/month.

Ann has never missed or even made a single late payment; and since she has was employed right out of school, she started paying off her loans right away. Still, last month, Ann received a letter in the mail about unpaid interest that was about to be added to the principal (less it be paid off). The amount of interest to be capitalized was $6000. Ann, frustrated that it was going to make her monthly payment go up, asked Tim for some help (she paid this bill separate from their other expenses). That’s when Tim asked to see her monthly statements and he figured out why:

$180,000 @ 7.5% Interest

The key to making sure you never have to deal with interest capitalization is to make monthly payments at least what your interest payments would be.  It’s actually very simple to figure out what Ann’s interest payments for Ann:

 [$180,000 * .075 (7.5% interest)] / 12 months = $1,125/month in interest

Since Ann had been paying only $700/month since the end of law school, her payments weren’t even enough to pay for the interest she’s being charged. As a result, the leftover interest payments get added to the principal balance of the loan (once a year). Since graduating law school, Ann’s student loan debt has increased a total of $11,000. But it get’s worse.  Now see what happens to the interest payments:

[$191,000 * .075 (7.5% interest)] / 12 months = $1,195/month in interest

Interest payments, are now $70 more expensive.  So not only does she owe $11,000 more than the original loan, but if she kept paying the same monthly rate, it would increase faster (even more interest would capitalize next year).  Even with her (now) larger payments, (that would have just about broke even with the original monthly interest) she still won’t catch up with interest.

Because of interest owed on the loans, she could pay $1,200/month for the rest of her life and never pay off the debt – even though after 30 years that would be $432,000 in payments (about 3 times the original loan). Still, if she doesn’t at least catch up with interest, it will only continue to get worse. Not only that: it will get worse quicker.

Ann’s saving grace

Ann isn’t stupid. Believe it or not, she actually knows exactly what she’s doing. You see, part of the reason she decided to take the government job (other than the strict 9-5 hours and other nice benefits) was because it qualified as “public service” under the loan forgiveness plan according to The College Cost Reduction and Access Act of 2007. After 120 income contingent payments, the federal government is going to pick up the rest of the tab on her loans – regardless of what is left. Essentially, Ann has no incentive to pay off any principal, since it will be paid off for her. Realistically, she doesn’t have much incentive to keep even with interest since it will cost her nothing in the long-run. Interest that the government is essentially charging itself…

That is, unless something happens to her job or she doesn’t qualify for the program. Which is why Tim convinced Ann to at least keep up with interest for now. That way they’re not sitting on an increasingly volatile situation. And they’ll stop getting those letters reminding them how much her student debt increased.

Ann is lucky.  Do you realize how common this story is where the graduate doesn’t even have a job, so they find it hard to make a $1 payment (let alone $700).  Imagine where they would be by this point?  And that’s with no repayment program to fall back on…  Scary thought.

Some takeaways:

School is expensive, Student loans make it more expensive – Graduate school especially, particularly when graduate student loan rates are at 7.6% interest. If you need to take out loans to pay for the majority of your education, you could be paying for it for a very long time. Know what you’re getting into…run the numbers before you consider taking loans.

Stay on top of interest – Start paying your debt as soon as possible and do everything to keep in front of interest. Otherwise your debt will only get worse. The goal is to pay off the principal, so the bare minimum should be to not let that get any larger.

Don’t count on help – While Ann is smart to take advantage of the loan payback program, most people aren’t going to have this kind of help. Even with such help it isn’t a great idea letting interest capitalize the way she was. If something happens to her eligibility, it could have put her and Tim in a huge financial hole.

Other observations:

The interest rate is what’s really hurting Ann, here. Even a single point lower (to 6.5%) and her interest payments would be $150 cheaper – something she and Tim could handle and would allow them to start to pay down the principal. It seems backwards that people who are actually able to make payments to their loans would be hindered from doing so in a timely manner by high interest rates such as these.  It doesn’t seem fair.

Loan forgiveness programs create a very interesting moral hazard. Tim and Ann will be paying more than what they really need to (to qualify for loan forgiveness) just so they can avoid the capitalizing interest. But the truth is, they have no real incentive to do so other than the possibility of not qualifying for the program. In fact, they Ann has every incentive to pay as little as possible each month so long as the government picks up the check.  I suppose it doesn’t really matter as far as the federal government is concerned, they’re essentially charging the interest to themselves in these cases.

For my money, interest forgiveness to reward those who make consistent on-time payments would make much more sense.  Just a thought…