A lack of understanding regarding two critical facets of student loans can have a significant impact on your wealth. Let’s start with interest capitalization. When you borrow money, you have to pay for the use of that money. It’s called interest. Interest is usually charged as a percentage of your outstanding principal. For the example that follows, the numbers are as follows: a single, recent graduate who has an AGI of $140,000 that will go up by 3% each year. She has $400k of student loans with an average rate of 7%. When you join one of the government repayment plans (which you would most certainly do if you had 400k of debt), your loan balance works like a line a credit. In the example, the annual interest would be $28,000 a year. Under the PAYE plan, the required monthly payment (based on your income) would be about $12,000 a year. So after the first year, not only would you not pay down any of the principal (your 400k), you wouldn’t even pay all of the interest. In fact, you would have about $16,000 of “accrued interest” that would sit in a “bucket” until you either pay it off or the government forgives that debt (more on this later). Note: the $16,000 of accrued interest does not change how much interest you are paying on an annual basis. You still owe $28,000 a year in interest, and whatever you don’t pay just gets added to the accrued interest column. If we played this scenario all the way out to year 20, there would be a total amount of about $620,000 in outstanding debt (the original $400,000 loan plus the $220,000 in interest that never got paid).
Now, let’s fast forward to the end of year 8. Under this scenario, you would have approximately $113,000 of outstanding interest sitting in that accrued interest account. When you go to file your annual recertification paperwork (this is required each year to stay in the income-based repayment program), you are one day late. JUST ONE DAY! This can cause your interest to “capitalize.” That means that in year 9, your outstanding principal amount is now $513,000, which means that instead of incurring $28,000 a year in interest (7% of 400k), you are now incurring $35,000 a year in interest (7% of $513,000). By the time you reach year 20, your total outstanding debt amount would be about (assuming you recertify in time every year thereafter): $825,000. That’s $205,000 more because your interest capitalized at the beginning at of year 9.
One day of tardiness just cost your net worth $205,000… kind of. I’ll come back to that in a second. So you have to make sure you recertify every year and do so on time. In fact, I recommend you start three months early. Student loan servicers may mix up or lose paperwork, entering people in the wrong plan or not all. So be diligent, file your paperwork on time and make sure you check on them.
Now you might say, “All of my debt is going to get forgiven anyway. Why does it matter?” Well, you might be right. Under current legislation and probably for those currently enrolled in these programs, that may be true. Which is why I say it “kind of” costs your net worth $205,000. This leads me to my next point…
Taxable forgiveness. When you get to year 20 (under the PAYE plan), any outstanding debt gets forgiven. Throw a party because that’s really great. But… there’s a catch. All of that debt forgiveness is considered taxable income. In this scenario above, you would be earning about $250,000 in year 20 (140k with 3% income increase). If your outstanding debt is $620,000 and gets forgiven, THAT MEANS YOUR TAX BILL WILL BE BASED ON $820,000 OF INCOME. You could literally owe $100,000s in extra taxes. It is imperative that you meet with a tax advisor that understands how this works. It’s anyone’s guess as to what your actual tax bill will be in 20 or 25 years. But be aware, as it could be more than your entire earned income for that year. If you plan to go down the route of paying the minimum on your loans, make sure that you are anticipating a potential tax bill and saving money accordingly. For some people this can be a great strategy. But if you wait until the last minute to start planning for that tax bill, you could end up in a very bad situation.
Please feel free to contact me with any questions.
~Ryan Schulte, financial advisor