By the end of his first term in office, President Obama knew the federal student loan program was out of control. Default rates were up and millions of student borrowers had put their loans into forbearance or deferment because they were unable to make their monthly payments. Then in 2013, early in Obama’s second term, The Consumer Financial Protection Bureau issued a comprehensive report titled A Closer Look at the Trillion that sketched out the magnitude of the crisis.
What to do? President Obama chose to promote income-driven repayment plans (IDRs) to give borrowers short-term relief from oppressive monthly loan payments. Obama’s Department of Education rolled out two generous income-driven repayment plans: the PAYE program, which was announced in 2012; and REPAYE, introduced in 2016.
PAYE and REPAYE both require borrowers to make monthly payments equal to 10 percent of their adjusted gross income for 20 years: 240 payments in all. Borrowers who make regular payments but do not pay off their loans by the end of the repayment period will have their loans forgiven, but the cancelled debt is taxable to them as income.
The higher education industry loves PAYE and REPAYE, and what’s not to like? Neither plan requires colleges and universities to keep their costs in line or operate more efficiently. Students will continue borrowing more and more money to pay exorbitant tuition prices, but monthly payments will be manageable because they will be spread out over 20 years rather than ten.
But most people enrolling in PAYE or REPAYE are signing their own financial death warrants. By shifting to long-term, income-driven repayment plans, they become indentured servants to the government, paying a percentage of their income for the majority of their working lives.
And, as illustrated in an ongoing bankruptcy action, a lot of people who sign up for IDRs will be stone broke on the date they make their final payment.
In Murray v. Educational Credit Management Corporation, a Kansas bankruptcy judge granted a partial discharge of student-loan debt to Alan and Catherine Murray. The Murrays borrowed $77,000 to get bachelor’s and master’s degrees, and paid back 70 percent of what they borrowed.
Unfortunately, the Murrays were unable to make their monthly payments for a time, and they put their loans into deferment. Interest accrued over the years, and by the time they filed for bankruptcy, their student-loan indebtedness had grown to $311,000–four times what they borrowed.
A bankruptcy judge concluded that the Murrays had handled their loans in good faith but would never pay back their enormous debt–debt which was growing at the rate of $2,000 a month due to accruing interest. Thus, the judge discharged the interest on their debt, requiring them only to pay back the original amount they borrowed.
Educational Credit Management Corporation, the Murrays’ student-loan creditor, argued unsuccessfully that the Murrays should be place in a 20- or 25-year income-driven repayment plan. The bankruptcy judge rejected ECMC’s demand, pointing out that the Murrays would never pay back the amount they owed and would be faced with a huge tax bill 20 years from now when their loan balance would be forgiven.
ECMC appealed, arguing that the bankruptcy judge erred when he took tax consequences into account when he granted the Murrays a partial discharge of their student loans. Tax consequences are speculative, ECMC insisted; and in event, the Murrays would almost certainly be insolvent at the end of the 20-year repayment term, and therefore they would not have to pay taxes on the forgiven loan balance.
What an astonishing admission! ECMC basically conceded that the Murrays would be broke at the end of a 20-year repayment plan, when they would be in their late sixties.
So if you are a struggling student-loan borrower who is considering an IDR, the Murray case is a cautionary tale. If you elect this option, you almost certainly will never pay off your student loans because your monthly payments won’t cover accumulating interest.
Thus at the end of your repayment period–20 or 25 years from now–one of two things will happen. Either you will be faced with a huge tax bill because the amount of your forgiven loan is considered income by the IRS; or–as ECMC disarmingly admitted in the Murray case–you will be broke.
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