Monday, November 7, 2011

Doing the Math

Last Wednesday (November 2), our current President wrote a piece for The Harvard Crimson, called “We Can’t Wait: Helping Manage Student Loan Debt.” He mentions that he had recently announced at the University of Colorado at Denver “steps we’re taking to make college more affordable and to make it even easier for students like you to get out of debt faster.” 

So the plan should show steps affecting affordability and quicker debt repayment, right? For today’s math, we’ll just look at how his plan addresses the rate of debt repayment. Here are his word:

That’s why we’re making changes that will give about 1.6 million students the ability to cap their loan payments at 10 percent of their income starting next year. We’re also going to take steps to help you consolidate your loans so that instead of making multiple payments to multiple lenders every month, you only have to make one payment a month at a better interest rate. And we want to start giving students a simple fact sheet called “Know Before You Owe” so you can have all the information you need to make your own decision about paying for college. That’s something Michelle and I wish we had. 

Let’s summarize his plan’s points:

  1. Cap payments to 10 percent of income.
  2. Consolidate loans and make a single lower payment.
  3. Give students “Truth in Lending” disclosure.
Let’s wait on number 1 for a bit, and start with number 2. A consolidated loan is a new loan totaling the sum of government-subsidized loans, private, loans, and parent loans—in order to pay off those loans and have a new single payment. The consolidated interest rate might be lower than some loans, higher than others. But typically the consolidated loan is entered into not just for simplicity but for lower interest. With a lower overall interest rate, payments can actually go down without increasing payback time. 

This is great news! Except it isn’t news. This has been standard practice for students upon graduation for decades. It is the status quo, not a sudden new resolution to high student loan debt. 

Does number 3 lead to quicker payback of debt? The Truth in Lending Act (1968) requires disclosure in any kind of loan from credit cards to mortgages. Student loans offer additional information. The student is clearly told, not just the amount being financed, the interest rate, the finance charge, and total of payments (principal plus interest over the life of the loan), but will also have spelled out for him/her exactly what the monthly payment will be for each additional increment in student loan debt.

This is helpful information. Something Mr. President not only wishes he and Michelle had benefitted from—they did. For many years, the Truth in Lending Act has done exactly what Mr. President says his new idea will do. Again, what he is calling “Know Before You Owe” is not only the status quo, it has no effect on lowering college costs or increasing the speed of paying back student debt. 

So, if his plan includes an actual way to more rapidly pay back student debt, it must be number 1. Indeed, number 1 relates to repayment rate: the repayment rate will be lower or stay the same. If 10% of a person’s income is enough to cover the standard monthly payment, there will be no change, but if a person’s income is low enough that 10% is lower than the standard payment, then the payment will be only 10%, not all the way up to the standard payment. 

Let’s say a student graduates with $50,000 in student loans (higher than many, but he’s writing to Harvard students, so let’s say this is pretty common for the audience), and a rate of 6% (which may be at the low end), to be paid back over 10 years—then your monthly payment is $555.10.  That means your monthly gross income would need to be $5,551.00 or higher in order to meet this standard payment. That’s an annual income of $66,612. For Harvard graduates that might be in the range of possibility for a starting job, depending on field of study. But let’s just admit that isn’t a common starting rate for new college graduates across the country. 

So, let’s say a starting wage for a graduate is half that: $33,306 per year, or $2775.50 per month. What happens when you start with the same loan amount and same interest rate, but with a lower payment? You make more payments—464 payments instead of 120 payments. You’ll be paying interest on the remaining principal for 38 years (as opposed to 10), which means your actual interest will be considerably more. How much exactly?

  Interest rate
  Total principal to be repaid
  Length of loan
  Total interest paid over life of loan
  Total amount (principal plus interest) paid over life of loan
6% per year
38 years
6% per year
10 years

You take longer to pay back the amount, and end up paying 4.7 times more [I used this calculator] total interest—exactly the opposite of what Mr. President says the cap will accomplish. 

So when he says,  

These changes will make a real difference for millions of Americans. We’ll help more young people figure out how to afford college. We’ll put more money in your pocket after you graduate. We’ll make it easier to buy a house or save for retirement. And we’ll give our economy a boost at a time when it desperately needs it.

…should we believe him? I’m thinking I’d rather believe someone who has done the math.

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