The Moral Hazard of Loan Forgiveness Programs
I was playing around with a loan calculator and I figure it would be better to just take the loan forgiveness (even at 20 years via the Pay As Your Earn (PAYE) program, not just the 10 years via the Public Service Loan Forgiveness (PSLF) program) than to actually try to pay back my student loans. What do you think? Can that be right?
The scary thing is, that CAN be right. The higher your loan burden, and the lower your salary (and the more family members you have) the more likely it is that the right MATHEMATICAL answer to this question is to rack up as much debt as possible and delay paying it off for as long as possible. Let me show you an example using one of these loan calculators.
The Poor Doctor
Let’s assume we’ve got a pediatrician making just $100K who somehow manages to rack up $400K in student loan debt. Let’s say $150K of it is a subsidized 6.8% loan and $250K of it is an unsubsidized 8% loan. Terrible loan burden, we would all agree. The calculator I’m using doesn’t allow you to allow for the lower payments in residency, but suffice to say they will only make these numbers look better. For these purposes, we’ll assume the doctor is married with 2 children and makes $100K right out the gate from medical school. After 10 years, the loan will be forgiven via PSLF. After 20 years, the loan will be forgiven via PAYE. The calculator assumes a 5% income raise every year and a 3.3% poverty line raise every year (not unreasonable, but perhaps a bit optimistic on the income side). Plug all this into the calculator, and you end up with this:
Standard payments of $4,759 per month, or > 57% of your gross income for a total of $571,022 with the loans paid off after 10 years.
PAYE payments start at $503 per month and increase gradually over 20 years to $1553 per month or ~ 7% of your gross income for a total of $231,543. ($772K forgiven since your payments never even covered the interest on the loan.)
Even better if you can get PSLF, since you only made half as many payments. The calculator doesn’t cover this possibility, but your payments should total up to something around $100K (less with residency, much less with a long residency.)
The mathematical answer is clear. If this program stays in place, and if you have a massive loan burden, and if you have a low salary, the right answer is to pay the minimum and maximize your forgiveness. The problem with this is the moral hazard inherent in the issue. Since payments are based ONLY on income (adjusted gross income, line 38) then your incentive is to:
- Rack up as much debt as possible in college and med school.
- Never pay more than the minimum payment.
- Keep your AGI low by maximizing any above the line deductions (like retirement account contributions) and avoiding working too hard/making too much, getting a second job, starting a business, or sending your spouse to work.
[Update: There seems to be some confusion about what moral hazard is. “Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to hold some responsibility for the consequences of those actions.” So if a med student is expecting to have hundreds of thousands forgiven, he may take out more loans than he otherwise would and pay them back less than he otherwise could. It isn’t a “moral judgement” on the person. It is an economic term for the change in decision-making that results from not bearing the consequences/risk of the decision.]
In this way, you can throw the vast majority of the cost of your education on to the taxpayer. Now, I threw the entire cost of my medical school education on the taxpayer via the military HPSP “scholarship”, but rest assured the taxpayer got his pound of flesh out of the deal, mostly by paying me half of the national average for my specialty to do a job most docs would demand twice the national average for. I’ve got pretty mixed feelings about the taxpayer funding such a huge burden for the typical physician.
I also don’t like what happens to our behavior when we drag out our loans. It’s the same issue in the pay down debt vs invest question. Sure, investing is often the better move, IF YOU ACTUALLY INVEST. But the problem is that once we take our eye off the ball (the debt) we often spend the money instead, and paying down the debt is better than spending. So I fear that someone going for student loan forgiveness may become entirely too comfortable with debt (like mortgages, autos, and credit cards) and end up worse than he would have been had he just paid it off.
The Rich Doctor
Okay, you say, so that first example was kind of extreme. Let’s look at the other extreme. A single doc with no dependents with $100K in 6.8% subsidized loans making $500K. What does his situation look like? Let’s plug it into the calculator.
The standard payment is $1151 a month, or <3% of income. Income is too high for any reduced payments at all. The loan is paid off after 10 years, for a total of $138,096.
Somewhere In The Middle
Now, let’s assume a more typical situation. The average physician salary is $225K or so. The average physician student loan burden is $200K or so. What does that look like (remember we’re ignoring the value of residency, which tips the scale toward loan payment)? We’ll assume $100K in subsidized 6.8% loans and $100K in unsubsidized 8% loans. We’ll also assume married with 2 kids.
The standard payment is $2364 per month, or ~13% of income. After 10 years the loans are gone at a total cost of $283,633.
Under PAYE, the payment ranges from $1564 to 2364 (the full payment), or 8-13% of income. The loan will be paid off after 13 years, at a total cost of $323,515, and there will be no forgiveness. Was that worth it? I don’t know, you be the judge, but I don’t think so. I would have preferred to be out of debt at 2 years (by living like a resident) with a total cost of something like $215K. If this doc could have qualified for PSLF, especially when you include the benefit of the ultra-low payments in residency, and especially for a long residency/fellowship, then he still would have come out way ahead by making minimum PAYE payments. But when you have to wait 20 years for forgiveness, there’s a good chance that an average doc isn’t going to get any forgiveness at all, even with the residency effect.
One More Catch
PAYE forgiveness, unlike PSLF forgiveness, is fully taxable. Yes, read that again. Fully taxable at your marginal interest rate. Let’s go back to the poor doctor above who had $772K forgiven. His income that year is now $872K, and he’s going to owe something north of $250K (250% of his annual salary) in taxes just on that loan forgiveness. He’s still coming out ahead, but only by about $100K (plus the time value of money.)
The bottom line is that every doctor needs to run this calculation for himself. There are a lot of variables, so there will always be at least a little bit of guesswork. There is also the risk that the programs (PAYE forgiveness and PSLF forgiveness) will be modified, means-tested, or eliminated without grandfathering provisions. But here are the general rules:
- If you can qualify for PSLF by working at a 501(c)3, you should go for it.
- If you have a massive student loan burden ($300K+) and you are not an incredibly highly paid specialist, you should give very serious consideration (i.e. make some careful calculations using reasonable assumptions) to making PAYE payments for 20 years. But realize that you are swapping lower loan payments for a high tax bill balloon payment, so be sure to include that in your calculations.
- If you have an average loan burden and are poorly paid, you should give very serious consideration to making 20 years of PAYE payments, but again preparing for the balloon tax payment at 20 years by squirrelling away money for it.
- If you are relatively average (or better) in loan burden and salary, then refinance your loans upon residency graduation and live like a resident until they’re gone.
What do you think? What do you plan to do with your student loans? If you were graduating today with $300K in loans at 6-8%, what would you do? Comment below!