Written By: Dennis Gravitt
John and Mary Smith, aged 52 and 51 respectively, have a nice home, good jobs, and they liek to vacation in an exotic location at least once a year. Their combined after-tax incomes are well over $8,300 per month, or about $100k per year. With their household income, the Smiths appear to be doing well. Unfortunately, their household is like many, where consumptive lifestyles increase as incomes go up. The Smiths have grown to become impressive spenders, but unimpressive savers.
In their quest to obtain a fulfilling life through the accumulation of stuff and experiences, the Smiths have neglected areas which require a long-term perspective. In the midst of their spending, the Smiths have maintained a strong desire to help their two daughters pay for college. When the time came to send each of their daughters off to college, they decided to finance the expense by taking out Parent Plus loans.
When I met with the Smiths they had accumulated nearly $100,000 in student loan debt and more was on the way. They were just six months away from the start of monthly payments on the student loans for their oldest daughter. In another year’s time, payments on the loans they’d taken out for their younger daughter would also begin. Understandably, the Smiths were becoming increasingly worried over the daunting task of loan repayment.
For many of us, lifestyle choices and consumption habits are creating a similar scenario. When we attain an age when some folks are beginning to contemplate retirement, we are rendered incapable of considering a time when we too might be able to retire. Instead of making retirement plans, folks like the Smiths are trying to figure out how they’re going to afford their monthly student loan payments. As Mr. Smith explains it, “We didn’t want our children burdened with student loan debt. Besides,” he said, “we had an understanding with our daughters.” The plan was that they will help him pay off the loans as they are able. I’m not sure about you, but I wouldn’t want to be counting on the good-graces of even the best intentioned recent college grad.
As a better alternative to taking out the loans in his name, Mr. Smith might have insisted that each daughter take out loans in their own name. Had this been done, Mr. Smith would still have had the option to assist each daughter with their payments as planned, rather than being the one obligated to do so. Meanwhile, the portion of the loans attributed to the government would have retained their repayment flexibility. Among the possibilities for government student loans are four income-driven repayment plans. Each plan is based on the income of the borrower, and each is designed to make the loan payment more affordable. The plans include:
- Revised Pay As You Earn Repayment Plan (REPAYE Plan)
- Pay As You Earn Repayment Plan (PAYE Plan)
- Income-Based Repayment Plan (IBR Plan)
- Income-Contingent Repayment Plan (ICR Plan)
With loans financed by Mr. Smith, however, the government is going to base the repayment plan on his and his wife’s combined income, rather than their daughters’. Their annual incomes will eliminate any loan repayment flexibility. At a time when the Smiths could be playing catchup with their retirement savings, they will instead be servicing Mr. Smith’s student loans. And, yes, the loans do indeed belong to Mr. Smith, as he is the one whose name is listed on the loan applications.
With the weight of student loan payments pressing down on the Smiths, they are being forced to reconsider some of their current lifestyle choices. As owners of the debt incurred by their daughters, there’s an increased possibility of future relationship issues which can arise when one person owes money to the other. The only income driven repayment option to which Mr. Smith can avail himself is the Income-Contingent Repayment Plan.
While the Smiths have sufficient income to afford them the flexibility to adjust their lifestyle and accommodate the impending student loan payments, increasing numbers of cash-strapped Americans have more limited choices. Already financially challenged and struggling to make ends meet, students and their parents should be cautious before taking on student loan debt. Knowing your options and planning accordingly can smooth the transition from childhood to adulthood, and ease the difficulty of paying for college. As for the Smiths, let’s hope their health holds out so that they can continue working well into their retirement years.
To learn about each of these repayment plans, go to the U.S. Department of Education Federal Student Aid website.
Dennis Gravitt, CFP®, is a practicing financial planner and can be reached at dennis@ longrunfinancial.com.