Know Before You Owe: The Student Loan Crisis

By Lori Eason, CFP(R)

Last week, President Obama announced some changes to the government's plan to help ease the burden of student loan debt. This comes after the student debt level has reached $1 trillion, surpassing the amount of credit card debt in the United States. Student loan debt has also been a recurring theme brought up by many Occupy Wall Street protestors. Unfortunately college tuition and fees are rising at an alarming rate making it difficult for many parents and/or students to afford a college education, but is this proposal the relief students are looking for? While I could write a whole article on increasing college costs or my thoughts on this whole Occupy Wall Street movement, I'd like to focus on what changes the government is proposing and how they will help or hurt students.

To give a little background, I am very familiar with the burden of student loans. I fortunately only have a small amount of student loans because I received the Hope Scholarship which covered my entire tuition, my parents helped with my other expenses and I worked during the summers to save up for the school year. My husband, on the other hand, accumulated a large amount of student debt by going to pharmacy school. By marrying him, I get to join in on the fun of making payments on a student loan that feels like a second mortgage. Thankfully, he chose a field in which he knew he'd be able to pay back his debt. We are hoping to have it all paid off in 3 years.

So now on to the relief proposed. Last year President Obama presented and Congress approved the "Pay As You Earn" proposal which will allow students to cap their student loan payments at 10% of their discretionary income and this debt will be forgiven after 20 years of payments. This was actually a revision to the Income-Based Repayment IBR) plan signed in September 2007 by President George W. Bush. The previous version allowed students to cap their federal student loan payments at 15% of their discretionary income and forgave the debt after 25 years. The new, more lenient requirements were originally set to go into effect in 2014. Obama announced last week that they will go into effect in 2012 instead.

While this new proposal has certainly gained a lot of hype, the truth is it will only financially benefit a small handful of students and it will actually cause the majority of students who take advantage of it to pay more interest when all is said and done. Here's the scoop. To be eligible for the Income Based Repayment (IBR) plan, a former student's monthly payment based on a 10 year payment plan must be higher than 10% of his or her adjusted gross income. Because the IBR payment is a percentage of income, as the debtor's income increases, so will the payments required. If the debtor marries, the spouse's income will also be included in determining whether or not eligibility requirements are met. If the income reaches a level at which 10% is higher than the 10 year payment plan amount, a partial financial hardship no longer exists. At this point, any unpaid interest that has accumulated would be capitalized (added to principal) and the debtor will now be capped at the 10 year payment plan's monthly amount. In addition, if there was any additional capitalized interest owed, that would be paid after the original amount was paid off in 10 years. In many cases, if a student has a hard time finding a job, the amount of interest paid if any might not cover the interest outstanding which results in negative amortization and the loan balance growing.

So who stands to benefit from this proposal? The only group I can see financially benefiting would be those students who have an extremely high debt to income ratio over a long period of time. If the debtor's income remained fairly low for 20 years and he or she had a high loan balance, it is plausible that there would be a substantial amount of principal and accrued interest that would be forgiven. I think it's safe to say that college was clearly not the right path for an individual who can't find a decent paying job in 10 or 20 years.

I would certainly expect that the majority of college graduates, though they may have a hard time finding a well-paying job immediately, would eventually get to a level of income that would force them into the 10 year payment plan. This would most likely mean that they would pay off their student loans well before the 20 year point at which loan forgiveness occurs. That being said, in this job environment, I do believe there are students who would benefit in the short term from a cash flow standpoint. For those graduates who can't find a job or who are underemployed and unable to pay the standard payment, this could give them a break and allow them to get their feet on the ground. But keep in mind, if they don't meet the minimum interest payment, their outstanding loan balance will grow from the accumulation of unpaid interest during this time and when they do find an appropriate job, they will owe more.

I'd now like to switch gears to another fairly recent proposal that I am a fan of. Last year the Consumer Financial Protection Bureau was created and they have since introduced a "Know Before You Owe" campaign for student loans to help students make educated decisions when it comes to paying for college. I can honestly say that as a 17 year old kid, I had no idea what I was signing when I filled out my FASFA application so I am in favor of new steps to help students understand what they are getting into. Currently, schools send students a letter before each school year that details the financial aid they can use. The "Know Before You Owe" initiative proposes a "thought starter" form that colleges can use to present financial aid information to prospective students and their families. This new "thought starter" would not only show the total cost of attendance and the financial aid available to you, but it would also show how much the student would owe in student loans upon graduation and his or her estimated monthly payment. This would help give students a perspective on the impact of taking out student loans. It would also show the student's college cost compared to the national average of other categories of schools and the US student loan default, graduation, and retention rates.

In the same way that I believe owning a home is not a birth given right, neither is a college education. Students need to have access to affordable student loans, but they also need to learn responsibility and understand that this money must be paid back with interest. There are apparently people out there that think a college education should be free. When professors start lining up to work for free, maybe that will be an option. Many people who did not graduate from college have gone on to become very successful in their careers (Steve Jobs, Bill Gates, Henry Ford, etc.). I don't think that college is for everyone and a lot of thought needs to be put into what career to choose and how much is a reasonable amount to spend on a particular degree. This would mean researching job prospects and salaries of the field a student is interested in pursuing before deciding to take on student debt.

To conclude, I do believe there is room for improvement when it comes to educating students on loans and the student loan industry itself. How ironic is it that at 18 years old with no credit history you can't get a credit card, but yet you can borrow as much as your parents paid for their house? With this new "Pay as You Earn Proposal," the devil is in the details and these details are not easy to find or understand. I fear that some students might incorrectly assume that college loans just go away in 20 years and that they may be motivated to borrow more than what is necessary. This can be a very costly mistake even though students think it is an easy decision since after all, they are investing in their future. Keep in mind that student loans are not even dischargeable in normal bankruptcy proceedings, so students need to be very cautious when deciding how much is too much.