Student Loans and Financial Planning for the Young Doctor

I recently was invited to speak to the 4^th year dental students at USC. My subject was student loans and personal finance. The level of student loans these hard working, very bright students have accumulated is generally between $400,000 and $600,000. This isn’t unusual for students in other dental programs throughout the country. The questions I received from these students were:

1. What is the difference between IBR, PAYE, and REPAY and which program should I be on?
2. Can I just pay the minimum payments and have the remainder forgiven after 20 years?
3. What effect will student loans have on my ability to purchase a practice and home?
4. Should I refinance to private student loans?

To our readers who are interested in the answers to these questions, read on. Upon graduation, students can choose to enter into one of these programs, known generally as “Income Driven Repayment” programs, or IDRs. At that moment in time, two payment levels are marked into the record book:

1. A level 10-year payment plan. A $400,000 student loan, at 7% interest for 10 years would have a required payment of $4,644/month.
2. The IDR payment plan (IBR, PAYE, and REPAY). The payment is limited to 10% of your discretionary income. Discretionary income is defined as your Adjusted Gross Income, “AGI”, less 150% of the federal poverty levels, adjusted for you household size. If your first year out of dental school you earn $150,000 of income and you are single, your monthly payment would be $1,098/month.

Many of the features of IBR, PAYE, and REPAY are the same. For example, they all share the following features:

• Your monthly payment is capped at 10% of your discretionary income. So your initial monthly payment would be the same under all three programs. This is not true for IBR loans acquired before 2014. Those loans are capped at 15% of your discretionary income instead of 10%
• The government will provide an interest subsidy for the first three years in all three programs. This is very important. If your initial monthly payment is $1,098 (as in our example above), but the interest portion of the level 10-year payment plan above is $2,000, then your payment of $1,098 doesn’t even cover the interest portion. It’s short by $902. The government will pay that for you for the first three years in the program. During that time, you won’t see the balance rise. So make those first three years count!
• After the three years, the unpaid interest is added to your loan balance.
• If you file a joint tax return with your spouse, your income will be combined for purposes of determining your loan payment amount.
• All loans are forgiven upon death.
• Any forgiven debt in all three programs is taxable upon discharge.

In spite of the similarities, there are some key differences.

• Hardship:

IBR and PAYE require hardship. If 10% of your discretionary income rises to exceed the standard 10-year payment ($4,644 in our example), then you will be forced out of the program and into a 10-year level plan. This is important because if you’re forced out, any remaining balance on your loans after 20 years will not be forgiven. So if you’re forced out after 19 years, you will not receive loan forgiveness the following year for IBR and PAYE. Admittedly, at student loan levels of more than $400,000, you may be unlikely to ever be forced out of the IBR or PAYE programs. However, keep in mind that over time your income will rise while the original standard 10-year level payment doesn’t. This means that over time your IBR or PAYE payment might eventually exceed that 10-year level payment. If that happens you’ll lose the ability to have your student loans forgiven. See the chart in Appendix A for reference data I put together. The blue cells indicate when IBR/PAYE are no longer eligible.

• REPAYE on the other hand, does not require hardship.

In other words, you can make an unlimited amount of money, such as $2,000,000/year, and still remain on the REPAYE program. However, you will continue to pay 10% of your discretionary income. If that 10% exceeds the flat 10-year repayment of $4,644 in our example, then you’ll pay the higher amount. For example, if you earned $800,000 of AGI in a given year, your monthly REPAYE payment would be $6,515. In other words, your monthly payment under REPAYE is not capped at a dollar amount. It’s only capped as a % of income, whereas IBR and PAYE are capped at both.

• Loan Forgiveness:

IBR and PAYE have loan forgiveness after 20 years. REPAY is after 25 years. Just a cruel reminder that forgiven debt is taxable at your ordinary tax rates for all three programs.

• Interest:

Unpaid interest after three years is treated differently for each plan:

• IBR: After three years, all interest is capitalized (added) to the balance of your outstanding loans.
• PAYE: Like IBR, after three years, all interest is capitalized to the balance of your outstanding loan. However, the total capitalized interest cannot exceed 10% of your original loan balance. For example, if your original student loan balance was $400,000, then only $40,000 of interest can be capitalized to the loan, therefore maxing at a total loan balance of $440,000.
• PAYE: After three years, the government will continue to pay for 50% of any unpaid interest. The remainder will be capitalized to the balance of your student loans.

• Loan Consolidation:

PAYE might be more difficult to qualify for. Additionally, it requires you to consolidate all your eligible student loans.

• Spouses Income:

IBR and PAYE allow you to exclude your spouse’s income if you file Married Filing Separately. REPAY must always include the spouse’s income. To my young dental students, I generally recommend PAYE since it has a stop gap of 10% of your total loan balance. IBR and REPAYE don’t. That said, I recommend my clients eventually refinance into private student loans. If the goal is to have the loans forgiven after 20 or 25 years, you’re not thinking like a winner. Instead, you’re limiting yourself by design. And you’re staging yourself to pay a significant tax liability, up to 45% of the forgiven balance. I encourage my clients to aim high, achieve abnormal success, pay off their student loans, and even fund tax-deductible retirement plans. The goal shouldn’t be to maximize government subsidies, but rather to maximize accumulated net worth. To me, it’s a dramatic difference in mindset. One will get to financial independence while the other likely will not. To that end, I encourage clients to follow this timeline in their path of financial success, starting with graduation. The trick to success is keeping your personal expenses low during the early years out of school. How much you spend relative to your income is what I call your “consumption-to-income” ratio. This ratio should remain below a certain level.  That ratio lowers as your income goes up to reflect a higher percentage of your income going to taxes. Here is a reference chart illustrating an appropriate consumption-to-income ratio. You should be spending less than the amount listed, showing annually and monthly.  If you’re a client of PracticeCFO and interested to know your Consumption-to-Income ratio, put in a request to your CFO Adviser in your next planning meeting.

* For example, if your income is $300,000, look at that column. Your consumption-to-income ratio is 53% or $13,250/month. ($159,000 divided by $300,000)

  On a macroeconomic level, the total student loans in our country are approaching 1.5 trillion among 45 million borrowers. Colleges and banks have made student loans a for-profit business. And it’s getting us into a consumer debt crisis. Given much of that debt will be paid by the US government from student loan forgiveness the writing is on the wall. Changes are around the corner. Some of these changes might include:

1. A tax incentive for employers that pay a portion of their employees’ student loans, similar to making 401K contributions on behalf of employees.
2. All repayment plans may be consolidated into one program; i.e. no more IBR, PAYE, and REPAYE. Just one plan, such as IDR.
3. The Public Service Loan Forgiveness program may be discontinued. This program allows for a forgiveness after 10 years of service in a qualified government or charitable work place.
4. Forgiveness timelines for graduate loans might extend to 30 years. (Undergraduate loans may reduce to 15 years)
5. It’s even possible forgiveness will be eliminated altogether, but limiting capitalized interest to only the first 10 years. But the full loan will eventually be paid off in its entirety.
6. The discretionary income cap may increase from 10% to 12.5 or 15%.

Student loans can be intimidating and create great anxiety. Stay positive. Like Andy Dufresne in Shawshank Redemption, with a good plan and a consistent effort, you can break free.   Appendix A: Examples of IBR/PAYE eligibility and loan payments today, in 10 years, and in 20 years based on original student loan levels, income, and family size. Blue fields indicate when a borrower is forced out of IBR/PAYE and no longer eligible for loan forgiveness. Note that REPAYE borrowers cannot be forced out of the program, regardless of income or student loan size. However, REPAY borrowers don’t receive forgiveness until 25 years (as opposed to 20 years for IBR/PAYE) and there is no cap on monthly payments. Wesley Read | PracticeCFO | President, CPA, CFP