My dad always says, "If it sounds too good to be true, it probably is."
With that in mind, let’s take a look at an idea that is taking up much debate on the national level –Income Based Student Loan Repayment. Sounds wonderful, huh?
Another attractive feature is that when you continue to pay back your loan without missing any payments for 20 years, your loan balance would be forgiven.
So, if you are faced with $80,000 in student loan debt, with a repayment schedule of $925 per month and only earning $45,000 per year, you might be thinking "sign me up." And some current students may think that it doesn’t matter how much money I borrow, Uncle Sam will pay off any loan balance I can’t afford.
You ask, "Is there a catch?" Here’s some info from the fine print. Primarily, the interest on your student loan does not stop accruing when you sign up for this program. In essence, if your payment is less than the interest that is being charged, you are not only paying down the principal, your loan balance is also increasing.
Compound interest is "the eighth wonder of the world" when it’s working for you in your savings. It’s a financial death toll when it’s working against you. Let me say that again, you are making payments for 20 years and your loan balance is increasing.
You may be thinking, "Uncle Sam will pay it off no matter the balance, so it doesn’t really hurt me, right?" On the contrary. You will need to know that the Internal Revenue Service consider "Loan Repayment" to be an income windfall, for which you will be subject to income tax at whatever the tax rate is in 20 years. And there is no free repayment schedule with the IRS.
This might make more sense if we put some real numbers to it. To be clear, these numbers are not reflective of any individual, just an example of what could happen under Income Based Repayment.
For example, the interest rate on Bob’s student loan is five percent. Bob’s income never changes, so his student loan payment remains the same over 20 years. Bob’s loan balance is $80,000. His income is $45,000 and the new payment is $300 per month. Making Bob repay, $3,600 per year – 12 x $300 – and the interest charged would be $4,000 per year. Which leaves the loan Bob is repaying increasing by $400 per year, not including the compounding.
Let’s jump ahead 20 years. This student has paid $72,000 towards his debt and his new loan balance is $88,000 dollars. Well, it’s 20 years later, so Uncle Sam is going to step in and pay $88,000 to clear this debt. Guess who is going to be given the tax bill?
That’s right, Bob. In some cases, this "windfall" of $88,000 pushes the person into the next tax bracket. Since we don’t know what taxes will be in 20 years, and are currently in a low tax environment, we can assume they won’t be going down. Thereby forcing Bob to pay, let’s say a 40% tax on the $88,000, or $35,200 in additional taxes the year that Uncle Sam "forgave" his debt.
To recap, Bob, paid $72,000 in loan repayment, and $35,200 or a total of $107,000. The significance being that Bob owed $80,000 and paid $107,000. How is this beneficial, again?
I urge caution. For some seeking higher education, student loans may be your only answer.
Just know all of the facts before you agree to a 20 year plan created by the government.
And did you consider your credit? Student loan debt shows up on your credit report and affects such aspects of living as your ability to qualify for a house. It might, I don’t know, but if you are considering the Income Based Repayment plan you should find out.
Michelle Larson is a Certified College Planning Specialist.
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