Many moons ago, around this time of year, I graduated from veterinary school. One of my last memories prior to graduation was my exit interview for my student loans. The memories are a little fuzzy now, but what I remember very clearly was the counselor handing me a packet of paper with a bunch of numbers on it. This was my amortization schedule, and it seemed to go on forever. The numbers were large, and they honestly didn’t seem real at the time. I had yet to earn an actual salary and live like a full fledged adult, so the numbers at that point didn’t make much sense. All I knew was that I owed a lot of money, and I was obligated by law to pay every single penny back, with interest of course.
I had a few choices. I could do a standard repayment over 10 years. I could consolidate and extend my payment over 30 years. There was also a repayment plan based on income (this was before the current IBR/PAYE/REPAYE options were available). PSLF was non-existent (if these acronyms don’t make sense, read this post for an overview). So what did I do?
Well, my debt to income ratio was 2:1. I was unmarried with no children at the time. I ran the numbers and decided it was best to consolidate my loans and pay it off in 30 years. That’s right, I was basically treating my student loans like a mortgage. A 30 year, fixed mortgage. And I was fine with it.
I was eager to finally be a grown up and earn real income. My idea of personal finance was to just make sure I wasn’t spending too much money. I had no idea what it meant to save for retirement or plan for the future. I was clueless as to how taxes played a large part in financial planning. I didn’t understand the importance of an emergency fund and insurance. I was just looking short term, which I think is completely normal for a young 20 something. Especially a young graduate who had no prior financial knowledge background. But just because something is normal doesn’t mean it’s smart.
As a society, we have become very cozy with the idea of debt. The ease in which we have access to money, in the form of credit or loans, is astounding. That’s why it’s considered completely normal to spend half of your life paying for a house. If you happen to have your mortgage paid off by the time you’re retired, you’re considered lucky.
Apparently, it’s also now considered completely normal to spend much of your adult life paying for your education. The introduction of loan forgiveness programs has not only normalized the extended time it takes to pay back student loans, but it also inherently assumes that you will never be able to pay everything back.
I don’t know about you, but that sounds crazy to me.
Don’t get me wrong. Due to the increase in tuition far outpacing inflation and wages combined, there are really no good options left. When you’re seeing graduates owing more than 3 times their salary, the numbers simply do not work out. They literally cannot afford these payments if they do not have the forgiveness option.
In this post, I want to focus on those borrowers that are in the gray area. These are veterinarians who have a debt to income ratio of around 1.5:1, maybe 2:1 at the most. They run the numbers, and it’s feasible for them to pay it off in 10 years. But they also have this option to either stretch out their loans to a longer term or have their loans forgiven. What should they do?
Let’s explore a situation where a new graduate, Dr. Joe Calico, has a 1.5 debt to income ratio.
Student loans: $112,500
Loan interest: 6%
Marital status: Single
No other debt
Here are his student loan repayment options:
|Standard repayment plan||Extended repayment plan||IBR/PAYE|
|Monthly payment (initial)||$1,249||$674||$474|
|Monthly payment (end)||$1,249||$674||$968|
|Number of years||10||30||20|
The first question is: Can he afford the standard repayment? This depends completely on his other living expenses. Let’s work backwards and come up with a living expenses number.
Gross salary: $75,000
Retirement contribution: $2,250 (enough to get an employer match)
Roth IRA: $5,500
Health insurance: $3,000
Student loans: $1,249 per month= $14,988 annually
Total taxes, retirement, health insurance, and student loans: $45,738
When we subtract this amount from his gross salary, we get the amount of money that he can expect to use towards other living expenses.
$75,000-$45,738= $29,262 annual living expenses
$29,262/12= $2,438.50 monthly living expenses
Can he live off of just over $2,400 a month? Remember, this $2,400 needs to include everything from housing, food, transportation, utilities, savings, disability insurance, charitable donations, fun money….the list can go on and on.
This is where personal finance becomes very personal. Whether $2,400 is enough will depend largely on where he lives and how he spends his money. If he lives in a low cost of living area and is not a spendthrift, then he can make this happen. But if housing alone takes up the majority of his $2,400 (think very high cost of living locations, like NYC and the Bay Area), then the numbers can get tight very quickly.
In this case, let’s say that he can afford the standard repayment plan. But he’s wary of spending that much per month on his student loans because the lower payments seem much more attractive, giving him more take-home pay to spend however he’d like.
THE STANDARD REPAYMENT PLAN- PROS AND CONS
- He is completely done with paying back his loans in 10 years (or less if he pays more than the minimum monthly payment). Once that debt is gone, it’s gone forever.
- A higher monthly payment is a form of forced savings. It will force him to learn to live with less discretionary income. This sets a good precedent for saving in the future if he is used to living off a smaller portion of his income. He won’t be as tempted to upgrade his lifestyle if he is content with what he has now.
- He will get a “bonus” of $1,249 per month when he’s done paying his loans. He can use that extra money however he sees fit- hopefully he will use it in a fiscally responsible manner.
- He will see the highest monthly payment under this plan. This will leave him with less discretionary income in his budget.
- If he had gone ahead and invested the difference between a standard repayment versus any other lower repayment option, he may miss out on any potential gains he could have made in those investment accounts (examples are retirement and taxable accounts).
Let’s explore this last point a little more in-depth since this is a reason that many people are reluctant to pay down their debt. They feel that they will get better returns by investing.
How much can we theoretically make if we invest the difference between the standard repayment ($1,249) and the average between the first and last payments for IBR/PAYE ($720)= $529 for 20 years?
Using this calculator and assuming we’re starting with $1,000 in a retirement account:
6% return: $248,952
8% return: $318,596
Now let’s calculate the amount we would make if we were to invest the full $1,249 over 10 years, presumably after the 10 year mark when the loans are completely paid off:
6% return: $207,528
8% return: $232,243
The numbers seem to tell us that it’s a no-brainer: just go for forgiveness and invest the difference. Here are a few notes about that option:
- Assuming that you’re not in PSLF (which most veterinarians will not qualify for), then you will need to pay taxes on the amount forgiven. That amount will be approximately $18,000 if you’re in the 25% bracket, so when taking that into account, you are shrinking the gap between both scenarios because you will need to use some of that invested money to pay taxes on the amount forgiven.
- Remember, we are hoping to get a 6-8% return. However, no one has a crystal ball this far in the future, and we have no idea what sort of returns you will get from your investments. If you make poor investing choices, such as investing in nothing but a handful of stocks or trying to time the market, then you could very well lose money in the long term.
- We are also assuming that you are dutifully investing the difference every single month for 20 years. Keep reading to see why that might not happen.
EXTENDED REPAYMENT PROGRAM
The only reason he would extend the term of his loan repayment is if he expects a significant increase in his income in order to aggressively pay off his loan. This is similar to signing up for a 30 year mortgage with the hopes that refinancing and extra payments will allow you to pay off the loan faster.
However, if he ends up paying the entire 30 year term, whether it was due to lack of discipline or other financial obligations outside of his control, then he is easily paying the most using this plan.
LOAN FORGIVENESS PLAN
By far, the biggest reason he would go for a loan forgiveness plan is to have a substantially lower monthly payment. This will free up his cash flow to pay for other expenses.
So why should he NOT go with this option?
- As mentioned above, if he’s not enrolled in PSLF, he will likely pay a very large tax bill since the amount forgiven is counted as income. He will need to start saving right now in order to anticipate paying off the “tax bomb.”
- Speaking of taxes, tax laws and laws related to student loans are always subject to change. Whether that change will benefit him is an unknown. He has to be okay with a degree of uncertainty about how future legislation will affect his loans.
- He will need to go through the hassle of extra paperwork, verifying his income each year in order to calculate his loan payments for a loan forgiveness program.
- If he gets married, this will add another layer of complication. He will have to think about how to file his taxes (married, filing jointly versus married, filing separately) and household income, as these choices can have a great impact on how much he is paying.
- He is extending the amount of time he is paying debt. If he is debt-averse, he is essentially stuck paying his student loans for the next couple of decades because it does not make any sense to make extra payments if he’s planning on getting his loans forgiven.
COMPETITION FOR YOUR MONEY
Those who are young and single tend to have finances that are fairly simple. You may be up to your ears in debt, but your expenses usually fall under fewer categories. As you get older and go through different life stages, the competition for your money becomes fierce. You become a “real” grown up and buy a house- now you have a mortgage and all of the expenses that go along with home ownership. At some point you buy a car- hello car loan! You may decide to get married- now you have to think about how to combine finances. If your spouse comes into the marriage with debt, you now have double the fun of figuring out how to manage your debt. Your spouse’s car died- time to get another car. Maybe you start a family- now you have to factor in the myriad of costs that go along with having children (of which there are many, I can speak from experience). You will need to increase your life and disability insurance coverage. You run up a medical bill because you had an emergency appendectomy. Your dog (of course) was HBC and required an extended stay at the specialty hospital. Your parents are becoming more frail and their health is declining- they need some financial support.
Do you really need to continue paying your student loans through all of this? Or any form of debt, for that matter? This is exactly why, even if you have the best of intentions to invest your extra money, it’s much too easy for other, more pressing matters to present themselves. Unless you are very disciplined about setting money aside to invest, investing falls further down the priority list, and your wealth-building momentum is lost.
I started my loan repayment process with the mindset that it was going to be a fixed cost for 30 years. Despite the fact that the interest rate was very low, I eventually changed my mind and no longer wanted to make these student loan payments until I was near retirement age. I didn’t care what sort of potential gains I was missing out on, because they were potential, not guaranteed like paying down debt. I wanted this debt gone and out of my life forever. The idea of using some extra money in my spending plan to pay down this liability to zero so that I could build my net worth looked more and more appealing as time went on. I am proud to say that 30-year student loan “mortgage” has been paid off well ahead of schedule.
If you were to find yourself in Dr. Calico’s situation, where the choice between paying off the loan versus going on a loan forgiveness plan is not clear cut, what would you do? Do you think you can be aggressive and pay off the loan as soon as possible? Or are you more comfortable treating your loan like a 30-year mortgage?