“Your education loan debt represents a serious financial commitment which must be repaid. A default on any loan engenders serious consequences, including possible legal action against you by the lender, the government, or both.” (ABA-LSAC Official Guide to ABA Law Schools, 2013 edition (37) [PDF]
Contrary to the Official Guide‘s dire warnings, law school debt repayment is no longer a simple “pay-or-else” proposition. The likelihood that a recent law school debtor will default on his or her loans is now very low thanks to the U.S. Department of Education’s new repayment option for paying off federal guaranteed and direct student loans: Income-Based Repayment (IBR) and its 10-year public service complement, Income-Contingent Repayment (ICR). IBR is somewhat complicated, and revisions to the rules will go into effect in 2014 if not sooner. Here is a brief explanation of how the new repayment plan works:
• All federally guaranteed or direct loans qualify for IBR except PLUS Loans made to parents, consolidation loans including PLUS Loans made to parents, and federal loans consolidated with private loans. Most law students who use up to $20,500 in direct unsubsidized loans (at 6.8 percent interest) and unlimited Grad PLUS loans (at 7.9 percent interest) are eligible for IBR, but the government averages the interest rate it charges on those loans to 7.35 percent. Loans in default are ineligible.
• Debtors can take advantage of IBR if they can demonstrate that they have a “partial financial hardship,” which means that their monthly payments under IBR would be less than what they would pay under a 10-year standard repayment plan.
• IBR requires debtors to pay 15 percent of their “discretionary income” divided by 12 months. Discretionary income is the difference between the debtor’s “adjusted gross income” and 1.5 times the U.S. Department of Health and Human Services’s poverty guidelines for the debtor’s state and family size. The 2012 poverty guideline for the contiguous 48 states was $11,170 plus $3,960 for each additional family member, including spouses. The guidelines are indexed to inflation and additional information on them can be found here.
• After 25 years under IBR, the government cancels the loan, but the debtor must pay income tax on the canceled amount. Debtors who make 120 monthly payments while working full-time in a public service position will have their loans canceled after 10 years but are not required to pay income tax.
• Critically, interest does not capitalize onto loan principal while under IBR, which means that unpaid debts don’t balloon out of control.
• IBR requires the debtor to document his or her income each year and send it to the Department of Education.
• Starting in 2014, debtors will only have to pay 10 percent of their discretionary income while on IBR, and their debts will be canceled in 20 years instead of 25. President Barack Obama’s Pay-As-You-Earn plan, which is a proposed set of executive orders that would accelerate these reforms to 2013, has not been authorized yet.
There are a few other details about IBR that I won’t go too deeply into, such as the poverty guidelines in Alaska and Hawaii, whether the debtor is married and filing income taxes jointly, or whether employed family members are subtracted from the debtor’s discretionary income, but those interested can learn more on the Department of Education’s website.
IBR is calibrated for typical college graduates who have less than $30,000 in student loan debt. Its proponents did not contemplate the already high and ever-increasing costs of professional education coupled with acute professional oversaturation and underemployment. With so many law school graduates trying to enter the workforce with six-figure debts and very poor short- and long-term employment prospects, the likelihood that the government will be forced to cancel large amounts of law school debt in 20-25 years is high. As a result, the question floating in the legal education community is just how unpayable are most law school debts?
The Internet’s ubiquitous IBR calculators don’t answer this question, so instead I’ve “cracked” (not a challenge) the IBR formula to show how much “adjusted gross income” is necessary to claim a “partial financial hardship” for a given amount of debt. The following chart depicts the partial financial hardship limit under the current plan (15 percent of discretionary income) and how it will change when the reduction to 10 percent of discretionary income takes effect, whether in 2014 or sooner. Eagle-eyed readers will note a slight distortion in the lower left corner that accounts for the fact that law students are eligible for up to $20,500 unsubsidized Stafford loans, which students will generally take before on before the more expensive Grad PLUS loans due to their lower interest rates.
The data labels at $80,000 and $120,000 represent the weighted average public and private law school debt, $82,000 and $119,000, respectively, for the 37,000 class of 2011 law graduates who financed their legal educations with debt, taken from U.S. News and the Official Guide. Interest accrued while in school and undergraduate debt are not included. Some debtors may have taken out private loans, but my hunch is that’s unlikely because Grad PLUS Loans are unlimited and have a lower, fixed interest rate. The change in discretionary income levels will easily ensure that a large majority of law school debtors will be eligible for IBR.
Assuming the president authorizes the Pay-As-You-Earn changes—and the provision canceling IBR loans after 20 years goes into effect—the following questions remain:
• How much adjusted gross income is necessary at a given debt level for IBR payments to apply to loan principal?
• Because monthly IBR payments are a fraction of those made under the 10-year standard repayment plan, at what income level would a debtor have lower monthly payments on a 25-year extended repayment plan?
• At what income level would the loan be retired in 20 years or less, avoiding cancelation, the resulting tax liability, and loss to the government?
Behold, the answer:
Debtors with incomes in the red zone will not only face a strong likelihood of cancelation after 20 years but will also see no reduction in their loan principal on a month-to-month basis. Without significant income increases debtors will categorize their full canceled loan principal as income for tax purposes.
The area between the purple and blue lines shows that IBR might not be the best option for reducing monthly payments for some high-income debtors. People who do make their way into high-income positions after graduation and remain in them may prefer the extended repayment plan to IBR.
Policy discussion on IBR, however, should focus on the green line. Importantly, it’s not static because every IBR payment below it must be offset by payments above it for the loan to be retired before cancellation. In other words, the green line pivots upward the longer debtors’ payments are below it, increasing the likelihood that the loans will be canceled and the government will lose money on them.
The green line shifts to these levels over time.
As a reminder, the poverty guidelines adjust for inflation, which means that without real income increases debtors will stay in place, unless they are paying down some loan principal in which case their positions on the IBR Income Thresholds chart shifts leftward.
If the past is any guide, inflation-adjusted average earnings for all workers with professional degrees have only grown by 1.0 percent annually since 1991, and even that’s a little generous.
(Source: Census Bureau, Table P-28)
As for how much law graduates are earning today, the median salary for full-time long-term employed class of 2011 graduates was $60,000, with 75 percent earning less than $100,000. NALP [PDF] arrived at this median from 18,630 employed graduates who reported their salary at all, and given that underemployed and self-employed graduates are the least likely to report their incomes (if they even know them) it’s plausible that between 26,000 and 37,000 graduates out of 44,495 had incomes substantially below the green line. Worse, NALP recently reported double-digit starting salary declines between 2009 and 2011, which combined with inflation, productivity growth in the legal sector, and increasing student debt burdens indicates a long-term trend of IBR losses for the government on law school debt in 20–25 years.
One response to this grim scenario is that the losses on law school debt will be offset by extra interest payments made by a large number of college graduates. This may be true, but that doesn’t mean the government should do nothing to mitigate loan losses in some programs and not others. Moreover, earlier this year, the Congressional Budget Office released a policy paper noting that due to flaws in current federal accounting laws, the government will actually lose money on direct loans to students [PDF], which suggests that no offset will occur. To my knowledge the CBO has not studied the long-term budget impact of IBR, nor has it discussed if IBR was included in any calculations of the value of the student loan program.
Economist Michael Hudson has an apt aphorism: Debts that can’t be repaid, won’t be. Most law school debts will not be repaid, and hundreds of thousands of law graduates will be handing the government 10 percent of their discretionary income for degrees that do little to improve their productivity. Although IBR will keep law graduates out of permanent debt servitude to the government, it was intended to help college graduates avoid hardship deferments and defaults. It was not meant to be a bureaucratic, protracted Chapter 13 bankruptcy repayment plan that coincidentally allows the Department of Education to conceal the effective default rate on large federal student loans. A future deficit-obsessed legislature will probably repeal or at least modify IBR in several years when the losses become apparent, but a more rational solution would be restoring bankruptcy protection to all student loans and permanently ending the madness.
Matt Leichter is a writer and attorney licensed in Wisconsin and New York, and he holds a master’s degree in International Affairs from Marquette University. He operates The Law School Tuition Bubble, which archives, chronicles, and analyzes the deteriorating American legal education system. It is also a platform for higher education and student debt reform.