A bombshell report from the Government Accountability Office (GAO) on Wednesday shattered faulty accounting from the Department of Education on the cost of the Federal Student Loan Program. The new cost estimate to taxpayers for all loans issued through 2017 is expected to be $108 billion, far higher than originally expected. In my student loan consulting business, I’ve saved almost 100 clients over $10 million in the past two months. Almost all of this money was at the expense of the US government.
The GAO report’s cost projections for student loans through 2017 are far too low, and the report includes no costs for future years of loan issuance under current rules. Based on what I see as a private student loan consultant, the US will forgive $1 trillion of student debt over the next 20 years. The government created one of the largest entitlement programs in history by accident, making college mostly free for millions of Americans if they use the loan rules to their advantage.
The Government Underestimates the Rate of Tuition Growth
Consider that in the first quarter of 2005, total student loan debt stood at $363 billion. Now in the fourth quarter of 2016, total student loan debt is at least $1.46 trillion. This is an annual growth rate above 13%. Why has student loan debt exploded so violently? One of the primary reasons is that the growth in tuition and fees at colleges and universities has been relentless.
Over the past 10 years, the cost of attending a public four year instititution has gone up at about 3.5% above the rate of inflation annually. For private colleges, that rate of growth was 2.4%. From working with clients, my estimate is that graduate program cost has grown at a faster rate than four year bachelor’s programs.
Tuition Will Still Grow at a Faster Rate than Inflation, at Least for a While
Notably, the rate of tuition growth slowed about 0.5% over the past 10 years as compared to the 90s and 80s. Obviously, college cannot continually grow at a rate above inflation forever or else the college industrial complex would be larger than the entire economy. Therefore, assume the rate of growth in tuition is simply 2% above the rate of inflation over the next 20 years.
The GAO report implied that Department of Education staffers didn’t even understand inflation. I’m assuming their models for the future do not account for tuition growing at a rate that exceeds CPI. With tuition and fees growing so quickly, the cost of all the other aspects of the student loan program are also higher. This compound effect is not being modeled correctly.
Part of the tuition cost increase is the declining state support of public institutions, which then must increase tuition to maintain their programs. As the rate of private college tuition growth was slower than public tuition growth, this storyline holds some truth. However, it still does not account for the other 2% to 3% above inflation growth that has been tacked onto tuition and fees over the past 10 years.
Colleges and Universities are Unbelievably Greedy
The simple explanation is that Wall Street bankers and university administrators have a lot in common. Even though most colleges and universities are not for profits, they are among the greediest institutions in the world. Look at the expense of buildings at most colleges over the past 10 years. Gyms rival those at the best Olympic facilities, the dining halls have the latest electronics and flat screens, and every lecture hall is quadruple LEED Gold certified. Associate Deans seem to have Associate Deans, and there are Senior Vice Presidents for everything. University of New Hampshire even spent $17,000 on a table.
For these reasons, I estimate that the cost of college will grow and that federal student loans will finance the vast majority of the expansion. The Department of Education says that their expected subsidy rate for new direct student loan issuance is over 20%. As a result, I estimate an additional $150 billion in costs over the next 20 years from applying the generous federal loan program benefits to a higher total dollar amount of student debt.
The Public Service Loan Forgiveness Program Assumptions Are Horribly Wrong
Maybe you’ve heard of the Public Service Loan Forgiveness program (PSLF). Under PSLF, after 10 years of qualifying monthly payments on an income based repayment plan, the government pays off the student loan balance of the borrower tax free. To illustrate how badly the Department of Education is forecasting the cost of this benefit, the GAO report says Education expected 0 people to take advantage of PSLF in its first year of forgiveness in 2017. The reasoning? Officials said that not many borrowers had asked them about forgiveness yet.
About 25% of the American workforce is eligible for PSLF. The only requirement is working in a 501c3 or government employer. That means surgeons at not for profit hospitals, zoo veterinarians, community health center pharmacists, assistant district attorneys, teachers, and all government employees qualify. The sky is the limit for this benefit.
Borrowers with High Debt Loads Are Flocking to the Public Sector
Here’s what I’m seeing in my student loan practice. People are quitting their private employers to take up jobs in the public sector SOLELY for this benefit. Dentists are trying to set up not for profit practices. Veterinarians are searching for full time shelter jobs and part time private practice jobs to supplement their income. Lawyers are building their reputation in the public sector first before switching to a higher paying law firm. Pharmacists suddenly want to work at hospitals and ignore CVS and Walgreen’s opportunities. Doctors are doing extended fellowship training to maximize their loan forgiveness benefit along with their future expected income.
The Department of Education apparently does not understand that people respond to incentives. The assumed participation rate in PSLF should be 25% of borrowers. Currently, a little over 600,000 people are working towards the program. If you multiply the total number of borrowers (>40 million) by 25%, you get a staggering number of people who will pay a small fraction of their college cost.
If you use a more realistic assumption for PSLF participation, I can easily see the total cost from the program exceeding $200 billion over the next 20 years.
There Will Be Mass Tax Defaults on Private Sector Loan Forgiveness
Under current loan rules, private sector employees who participate in the income based repayment plans for 20-25 years will have their loans forgiven at the end of the period. However, to call this forgiveness is a bit of a misstatement. What actually happens is the total remaining balance gets added onto the borrower’s taxable income that year. The borrower must then write a check to federal, state, and local tax authorities.
Consider who will be taking advantage of this rule. It will be graduate degree holders with hundreds of thousands of debt. Over 60% of people do not have $1000 in an emergency fund. About half of my clients will owe over $100,000 to the government when their loans get forgiven under PAYE, IBR, or REPAYE, the three major income based repayment plans.
I prepare my clients for this tax liability by encouraging them to save in an investment account. What about the folks I don’t speak with? Does the government truly believe they will be able to ask for $200,000 from a late career veterinarian in 25 years and actually receive ANY of it? Does the government think a dentist will be able to come up with $400,000 to cover the taxes on their $1 million forgiven loan balance?
No One in Government Has Thought About How to Collect Six Figure Tax Penalties Required Under Their Policy
I see no estimates anywhere that incorporate default on future tax penalties. Based on the level of sophistication of the Dept. of Education implied by the GAO in their report, I doubt many of them have even thought about this. One of three things will happen for borrowers who have not prepared for the massive tax penalties they’ll owe in 20-25 years. Either they will face the full weight of the IRS who will attempt collection through their powerful tools, they’ll declare bankruptcy, or Congress will give them some sort of bailout and forgive much of what they owe tax free.
Regardless, I see none of these scenarios modeled in the GAO report. I think the cost of these defaults will not be realized for at least 10 years, but when they start we’ll finally see how devastatingly high the cost of college truly is. Unfortunately, it will be taxpayers picking up most of the bill. I think the cost of private sector loan forgiveness tax defaults will be at least $200 billion over the next 20 years.
There Will Be Creative Accounting Used to Minimize the Tax Burden of Loan Forgiveness
The tax rate I model in my student loan consults for payment of the tax penalty under private sector loan forgiveness is 43.4% for federal and 5% for state and local. That’s likely too high. I just had a conversation with a dentist client recently who told me that when he has his loan balance forgiven, he will just buy a bunch of equipment in that year and try to depreciate it all right away to create losses. I’m no accountant, but I know that CPAs are very good at figuring out loopholes to do things like this. All you’d need is a bunch of manufactured losses and the tax revenue on a $600,000 loan balance could go from $300,000 to $50,000 very easily.
Additionally, no one is modeling what happens when loan payment revenue declines from efforts to minimize adjusted gross income to reduce the size of monthly payments and thus increase the amount of loan forgiveness. If you take into account creative accounting tricks that will benefit the individuals who actually end up paying the full taxable penalty on their loan forgiveness, I could easily see if costing $100 billion over the next 20 years.
Default Percentages Will Rise
The current default rate on federal student debt is 11.2% right now, which is down from 11.8% the year prior. All good right? Wrong. When you include the larger number of folks putting off payment through deferment or forbearance or who are delinquent, over 40% aren’t paying anyting on their student debt.
Why is the published default rate only a little over 11% when 40% of borrowers are paying nothing on their student loans? I believe it’s because of manipulation of the federal student loan rules. If a college has defaults over 30%, that college could be shut down for defrauding their students and the federal government. However, what if the federal student loan rules included a provision that allowed students to put off payments for all kind of reasons such as ‘temporary financial hardship’ or unemployment? Now the colleges that abuse the federal student loan programs the most severely can evade the regulations by keeping their default percentage artificially low.
Eventually Default Statistics Will Start Showing Up, Despite Colleges’ Best Efforts to Hide Them
I had a friend who used to work in the financial aid office of a for profit college. Her coworkers would routinely call defaulting borrowers to try to get them on forbearance and deferment so they would not have to pay anything, but would also not show up in the default statistics that went to the federal government. This is happening at not for profit college aid offices too.
Eventually the 40% of borrowers not making payments will be forced to start paying something. I think it’s highly reasonable to assume that the default percentage rises to 20% over a long period of time. Given that the current federal student loan portfolio stands at about $1.2 trillion, I think it’s a very conservative estimate that $100 billion of federal student loans will default. Assume that the collection rate on this debt is 50%, so we have an additional $50 billion in costs for the federal student loan program.
Political Pressure Will Cause ‘Fraudulent College Debt’ to be Wiped Away
Remember all those ITT Tech commercials that would come on during Law and Order reruns? The federal government gave ITT Tech the death penalty and declared the company fraudulent. They had to shut their doors after extremely abusive lending practices and high default rates resulted in the company filing for bankruptcy protection. All students who went to ITT Tech institutions can now seek out tax free federal loan forgiveness because they went to a college that was shut down for fraud.
As I mentioned earlier, there are a bunch of colleges, for profit and not for profit, that are manipulating the default rate to avoid a similar fate as ITT Tech. Eventually they’ll be exposed as students’ deferment and forbearance periods expire. If it doesn’t happen in this upcoming administration, then it will happen in a future one. Debt from these institutions could also be wiped away.
Think of how many institutions out there could be closed down, and the tab for fraudulent college loan forgiveness could be enormous. I’ll assume a cost of $50 billion over the next 20 years just to be conservative.
Adoption of Cheaper PAYE and REPAYE Plans Will Cause Interest Subsidies to Soar
If you read the GAO report comments on page 16, Dept of Education officials apparently don’t believe that borrowers are smart enough to switch plans to the one that benefits them the most. I do a thorough review for clients of all available loan repayment plans, and frequently help move borrowers to a better option such as REPAYE or PAYE. If my clients had the time or desire to become knowledgeable about the loan plans, they could figure this out for themselves, and many people will. I’ve yet to do a consult and discover that the old IBR plan was better than REPAYE or PAYE.
The REPAYE and PAYE Plans Offer Incredible Benefits to Highly Indebted Borrowers
The Revised Pay As You Earn plan, or REPAYE for short, covers half of the interest balance not covered by the monthly payments. It’s extraordinarily generous. According to the Dept of Education, 570,000 people with $26.9 billion in student debt have taken advantage of this benefit by the third quarter of 2016. That is up from 190,000 people with $8.1 billion in student debt in the second quarter of 2016. I’ve helped a lot of people get set up on REPAYE in consults, most of whom were on the IBR plan, which is usually far more attractive to the government from a revenue standpoint. For many consults, I cost the government over $200,000 in future revenue by switching a client to REPAYE and out of IBR. Obviously that’s also $200,000 in savings for the client.
PAYE has seen an explosion of usage too. In the beginning of 2015, only 410,000 people were using it with a total debt load of $16.9 billion. Now that figure is up to 1 million people with $44.3 billion of debt as of the third quarter of 2016. PAYE limits interest capitalization to 10% of the original principal balance. This too is an enormous interest subsidy that will only grow when more people realize they can switch over to PAYE from the more expensive IBR. PAYE also has a shorter forgiveness period of only 20 years. That benefit too will cost billions of dollars once people realize they are eligible for it.
Clearly, whoever is in charge of modeling income based repayment plan usage at the Department of Education must have taken the past two years off work.
Each New Income Based Repayment Plan is More Generous than the Last
In the past couple of years, the administration changed IBR too in a way that will cost far more in the future than even the GAO expects. The Obama administration changed IBR from forgiveness in 25 years to forgiveness in 20 years. It also reduced the monthly payment requirement to 10% of discretionary income instead of 15%. In essence, we now have a “new IBR” plan. It’s only accessible to borrowers who took out their first loan after July 1, 2014. In my student loan consulting practice, I’ve yet to run into someone who’s eligible. Once the class of 2018 graduates, that will change and the subsidy costs will rise as well.
The GAO talks a lot about the unexpectedly high subsidy costs for income based repayment plans compared to the Standard, Extended, and Graduated repayment plans. The GAO report doesn’t adequately understand how much more profitable old IBR is compared to the new IBR, REPAYE, and PAYE plans. As fewer borrowers use the old IBR plan, subsidy costs will soar further. I think this will cost the taxpayer at least $100 billion over the next 20 years.
Many of the Federal Government’s Most Profitable Borrowers Have Not Heard About Private Refinancing Yet
Imagine if the federal government sold flood insurance in a city where 50% of people lived on a mountain and 50% of people lived in the valley. The government offered the same monthly premium to everyone regardless of the risk. The government relies on the income from the people paying too much on the mountain to fund the costs of insuring the people paying too little who live in the valley. Now imagine that private insurance companies could offer any premium they chose to whoever they wanted in this risk pool. You already know what would happen. The private companies would target the people living on the mountain and win their business by offering a much lower premium for the same coverage. The government would lose all this profit and insure every house in the flood plain at an expected loss.
The same thing is going on with student loans. I have private negotiated deals with the major private refinancing companies. If a borrower applies and gets a loan through these links, they get $300 and I get a bonus as well: Common Bond, Sofi, DRB. If they apply through this link, they get a $200 bonus and I get a bonus too: Credible.
In my consults I study whether the borrower will save more money on government repayment plans or private refinancing. If my client doesn’t qualify for PSLF and they have a good debt to income ratio, I get their interest rate cut and take away an extremely valuable income stream for the government that was meant to subsidize the bad credit risks in the pool.
Private Refinancing Awareness Will Lead to a Flood of Interest Income Leaving the Federal Loan Program
A lot of people are not aware that this opportunity to slash their student loan interest rate exists. Many clients told me they received a bunch of Sofi junk mail and threw it all away because they were wary of going with a private lender. Some friends told me that they were scared to refinance their debt because they think it’s a lot of work or that there are hefty upfront fees like they paid to refinance their mortgage.
Student loan refinancing is actually incredibly easy and consumer friendly. There are generally no origination fees and no prepayment penalties. Checking your rate takes 5 minutes, and the entire application process takes 15 to 30 minutes. Once more people realize how easy and awesome it is to save money on your student loans by refinancing, virtually all of the good credit risks are going to leave the federal pool as soon as they can. For many high income professionals, they will qualify for a better interest rate as soon as they sign their first employment contract.
As a general rule, most people with a debt to income ratio below 1.5 working in the private sector with cash to spare would be better off refinancing.
Even though a lot of people have already refinanced their loans, many folks still do not understand the benefits. These companies are just beginning to advertise on programs like Monday Night Football. As awareness of private refinancing rises, the Federal government will retain highly unprofitable loans in their loan portfolio. Borrowers who choose to remain in the federal loan program will either have a really high debt to income ratio or be seeking public service loan forgiveness.
The GAO Report Never Modeled Losing a Significant Percentage of the Best Borrowers from the Loan Pool
If wider knowledge of private refinancing causes 10% of the interest income from superior borrowers to leave the federal loan portfolio, it would be crushing to the program. Assume an average interest rate of 6% on the current $1.2 Trillion federal loan program. If 10% of borrowers leave, then the government loses $7.2 billion in interest income annually. Over 20 years, that cost would be $144 billion.
Assume that private refinancing companies build enough awareness that they pick off the 20% best borrowers every year going forward. It could be far higher than that rate too. Assume that new federal debt issuance is $100 billion with the same 6% interest rate. That would cost the government $1.2 billion a year in interest income, and $24 billion over 20 years using simplistic modeling and not adjusting for tuition inflation.
Therefore the total cost conservatively estimated would be around $168 billion from private refinancing companies picking off the best risks for their own loan portfolios.
My Total Estimated Cost of the Federal Student Loan Program over the Next 20 Years: $1.018 TRILLION
The $108 billion estimated price tag of the federal student loan program published by the GAO only includes loans issued through 2017. My estimate reflects a higher cost estimate than the GAO for these loans as well as future issuance over the next couple decades. Even so, my estimate could be completely wrong either on the downside or the upside.
Congress could eliminate many student loan benefits for future borrowers. I’d say there’s an 80% chance Congress severely curtails the PSLF program for new borrowers in the next 2 years. It’s just too unbelievably expensive. It will also begin to cause huge labor market distortions. Once people begin receiving tax free loan forgiveness in 2017 and private employers start losing employees en masse to not for profit employers, there will be a huge lobbying push to get rid of PSLF.
Congress could also crack down on for profit colleges, put a cap on the total annual student loan issuance, put restrictions on private companies stealing the most profitable customers, and eliminate the PAYE and REPAYE plans. Doing so would drastically reduce the cost of federal student loan programs.
On the other hand, Congress could also pass legislation making public colleges tuition free. It could pass a bill making private sector loan forgiveness tax free and maintain the generous PSLF program. It could pass legislation allowing millions of borrowers to get lower interest rates while remaining on the federal loan program. President-elect Trump could pass his ‘Trump plan,’ which allows for loan forgiveness after 15 years instead of the current most generous PAYE term of 20 years. If all of these proposals passed, the annual cost of student loan benefits could eventually exceed the budget for the entire Department of Defense.
See If I Can Save You Money at the Government’s Expense
Here’s the truth. Everyone’s tax rates are going to be higher in the future to pay for exorbitantly expensive benefits like the ones I mentioned in this article for student loans. After all, if the US will forgive $1 Trillion in student loans, the money has to come from the taxpayer.
You might as well take full advantage of the student loan benefits, because you will certainly be paying for them. If you don’t have the time or desire to become a student loan expert, consider hiring me for a low flat fee to study your loans and help you come up with a payback strategy. As I mentioned earlier, I’ve saved clients over $10 million over the life of their loans in the first two months of my startup’s existence.
Whether your perspective is that of a borrower, taxpayer, or both, I’d love to read your comments on this article below.
My business model here at Student Loan Planner, LLC is providing people student loan advice. Since November 30, 2016, I helped the average client save over $110,000 over the life of their loans on an average balance of $243,000. I only charge a one time flat fee. I perform a holistic loan analysis to see what your best available repayment options are and simulate what the future looks like, including estimating how to plan for a potential massive tax penalty. If you are facing a five or six figure debt burden, I urge you to contact me at email@example.com.