Student debt Archives - Finance Memos

Evaluating the Biden Administration Student Debt Discharge Proposal

The Biden Administration student debt discharge proposal is being challenged in the courts and may be overturned. This one-time debt relief proposal does not change the trajectory towards higher student debt burdens. A credible case can be made for student debt relief to prevent a shock to consumption when student loan payments are reinstated. However, the proposal is arbitrary in who it assists and is not the most economically efficient or fairest way to address the pending economic shock from the reinstatement of student loan obligations.

The student discharge proposal:

The Biden Administration is proposing a one-time discharge of federal student debt. Borrowers with a Pell grant can have up to $20,000 discharged. Borrowers with a federal loan that were not eligible for a Pell grant could receive a loan discharge of up to $10,000. The amount discharged cannot exceed the amount of the loan.

Taxpayers with income less than $125,000 (single filers) or $250,000 (married filers) are eligible for the one-time debt discharge.

Student loans taken out after June 20, 2022, are not eligible for the loan discharge program.

Six states have brought litigation to stop the Biden Administration student discharge program on grounds that the Biden Administration exceeded their legal authority and that the law damages institutions in their state. The Biden Administration claims their authority to provide student loan debt relief due to COVID stems from the 2003 Heroes Act which allows for relief under a national emergency and that the plaintiffs do not have standing to litigate this issue. The Supreme court has agreed to rule on this matter and the debt discharge proposal has been stayed pending the decision.

Some issues with the Debt Discharge Proposal:

Opponents of proposals to discharge student debt argue the programs are regressive because people with access to education due to their student loans will earn more over their lifetime than workers who never go to school. This view was espoused by the moderate candidates in the 2020 Democratic primary including Joe Biden.

The student loan debt relief package is a one-time benefit. It only favors people with debt incurred prior to June 2022. It does not benefit future student borrowers. It does not change the trajectory toward higher debt burdens for future cohorts of student borrowers.

The absence of debt relief for people taking out student loans after June 2022 is necessary because the legal justification of the program is the COVID emergency. It would be difficult to maintain that people taking out loans after June 2022 needed financial assistance because of COVID, at a time when all other COVID relief packages were ending.

The Biden Administration attempts to ameliorate concerns that student debt relief favors high income professionals over workers by imposing income limits on eligibility for the debt discharge and by having a larger level of debt discharge for people who initially had income low enough to qualify for a Pell grant. These arbitrary provisions don’t lead to the program automatically targeting the student borrowers who are most in need of assistance.

Income is highly variable, especially at the beginning of a person’s career. The need for the loan discharge depends on salaries over many years not salary in one arbitrary year.

A person starting her career in the year of the discharge at a modest starting salary would automatically receive the discharge. A person three years advanced on the same career path might not receive any financial assistance if her salary has risen. For example, the debt discharge will be available for a doctor who is a resident during the year of the debt discharge program but will be unavailable for an attending physician.

A person leaving a high-powered job a year (a law associate who does not become partner) after the financial discharge provision would not receive any financial assistance despite the decrease in salary.

Many medical students who take on hundreds of thousands of dollars of debt may be more deserving of a debt discharge than students with less debt and lower debt burdens.

The person who received a Pell grant may be better off than middle-class people who are ineligible for the Pell grant when the loan was granted.

The Biden Administration claims that the Heroes Act of 2003 gives the Administration the right to modify student loans in the case of a national emergency. The plaintiffs in this case are arguing that relief offered the proposal is broader than what is allowed under the law and that the COVID emergency was only a pre-text for the program.

The Biden Administration argues that without debt relief there will be a historically large increase in delinquencies and defaults. A less expensive way to reduce defaults might involve freezing interest payments and reducing monthly minimum payments for a year or two after reinstatement of loan payments. However, the Heroes Act does not state that financial relief must be offered in the most efficient way.

No one knows how the Court will rule. The Court is not well equipped to deal with the economic aspects of this issue. Congress has other levers, including the budgetary process and the debt limit, to force changes to the program.

The one-time debt relief proposal is at best a band aid. It does not address the continuing acceleration in college costs and student debt. The debt discharge proposal is only one component of the Biden Administrations efforts to assist student borrowers. Other programs including revisions to Income Driven Replacement (IDR) and some waivers for the discharge of current IDR loans will be addressed in a future post.

David Bernstein is the author of A 2024 Health Care Reform Agenda and Alternatives to the Biden Student Debt Plan.

Financial Tip #2: Prioritize debt reduction over saving for retirement

Tip #2: New entrants to the workforce, facing unprecedented levels of student debt, should prioritize debt reduction over saving for retirement.

Most students with substantial student debt should reduce or forego retirement savings until their debt levels become manageable. Students entering the workforce with substantial debt could reasonably forego saving for retirement for the first three years of their career. Potential advantages of pursuing a debt reduction strategy and the creation of an emergency fund over saving for retirement include:

Reduced lifetime student loan interest payments
Improved credit rating and reduced lifetime borrowing costs
Reduced likelihood of raiding retirement plan and incurring penalties and tax
Increased house equity and reduced stress associated with debt

Discussion of advantages of rapid student loan reduction at the expense of saving for retirement:

The decision to initially forego saving for retirement and earmark all available funds towards repayment of student debt leads to a substantial reduction in lifetime payments on student debt. Two examples of the magnitude of the reduction in lifetime student loan payments are presented below.

A student borrower starting her career with $30,000 in undergraduate loans could take out a 20-year student loan leading to a monthly payment of $198.82 and lifetime loan payments of $47,716. Alternatively, this student borrower could forego contributions to her 401(k) plan, increase student loan payments by $565.4 per month and pay off her student loan in 61 months. The new total student loan repayments are $33,837, a total savings of $13,879.

A second borrower with three student loans — a $35,000 undergraduate loan at 5.05%, a $40,000 graduate loan at 6.66% and a $25,000 private student loan at 10.00% — choosing the standard 20-year maturity on all loans has a monthly payment of $775 and realizes total lifetime payments of $200,633. The modification of the private loan to a five-year term initially increases the monthly student loan to $1,065. The total lifetime student loan debt payments for the person who repaid her private student loan in 5 years instead of 20 years and earmarks the reduced loan payment to further loan reduction is $146,271. This is a total lifetime savings of $54,362.

The student borrower who rapidly reduces or eliminates all student debt can increase savings for retirement once the monthly student debt payment falls or is eliminated. Furthermore, the rapid elimination of the high-interest-rate private student loan could facilitate refinancing of the remaining student debt at favorable terms.

The failure to maintain a good credit rating will lead to higher borrowing costs on all consumer loans and on mortgages in addition to higher lifetime student loan payments.

Assumptions on the impact of credit quality on interest rates were obtained for credit cards from WalletHub, for car loans from Nerd Wallet, for private student loans from Investopedia, and for mortgages from CNBC. The differential between interest rates on people with good and bad were 9.8 points for credit card debt, 7.0 points car loans, 10.0 points for private student loans, and 1.6 points for mortgage debt. The monthly cost of bad credit depends on the interest rate differential, the likely loan amount, and the maturity of the loan. The analysis presented here assumes a likely loan balance of $10,000 for credit cards, $15,000 for a car loan, $20,000 for a private student loan, and $300,000 for a mortgage. The analysis also assumes the borrower only paid interest on credit card debt and loan maturities were 60 months for car loans, 240 months for private student loans, and 360 months for mortgages. Based on these assumptions, the monthly cost of bad credit was $82 for credit cards, $49 for car loans, $124 for private student loans, and $277 for mortgages.

A person who fails to eliminate debt could end up with higher borrowing costs for their entire lifetime.

Increasingly, young adults are tapping 401(k) funds prior to retirement to meet current needs. Often individuals who raid their 401(k) plan prior to retirement incur additional income tax and financial penalties. A CNBC article reveals that nearly 60 percent of young workers have taken funds out of their 401(k) plan. A study by the Employment Benefit Research Institute (EBRI) reveals that 40 percent of terminated participants elect to prematurely withdraw 15 percent of plan assets. A poll of the Boston Research Group found 22 percent of people leaving their job cashed out their 401(k) plan intending to spend the funds. New entrants to the workforce who prioritize the reduction of student debt over saving for retirement will be less like to raid their retirement plan and incur tax and financial penalties.

Note from Tip #3 that people using Roth IRAs or Roth 401(k) plans are less likely to pay penalties and taxes on disbursements on retirement savings because the initial contribution to a Roth can be disbursed without penalty or tax. People with debt should start saving for retirement through relatively small contributions to Roth accounts rather than large contributions to traditional plans.

Many people who fail to prioritize debt payments struggle with debt burdens for a lifetime and fail to realize a secure financial future. A CNBC portrayal of the financial status of millennials found many adults near the age of 40 were highly leveraged struggling to pay down student debt, using innovative ways to obtain a down payment on a home and barely able to meet monthly mortgage payments. A 2019 Congressional Research Service Report found the percent of elderly with debt rose from 38% in 1989 to 61% in 2021. The Urban Institute reported the percent of people 65 and over with a mortgage rose from 21% in 1989 to 41% in 2019. A 2017 report by the Consumer Finance Protection Board found that the number of seniors with student debt increased from 700,000 to 2.8 million over the decade. Many of these problems and financial stresses could have been avoided if the student borrower entering the workforce had initially focused on debt reduction and the creation of an emergency fund rather than saving for retirement.

These problems will worsen if borrowers don’t start focusing on debt reduction over saving for retirement because many in the new cohort of borrowers are starting their careers with higher debt levels.

Concluding Thoughts: Many financial advisors stress saving for retirement over debt reduction. Fidelity, a leading investment firm, says young adults should attempt to have 401(k) wealth equal to their annual income at age 30. Workers without debt and with adequate liquidity for job-related expenses can and should contribute. Their returns will compound overtime and they will have a head start on retirement.

The Fidelity savings objective is unrealistic for most student borrowers with debt. The current cohort of people entering the workforce has more debt than any previous cohort. Average student debt for college graduates in 2019 was 26 percent higher in 2019 than 2009. The decision by a new worker with student debt to go full speed ahead on retirement savings instead of creating an emergency fund and rapidly retire student debt can and often does lead to disaster. The young adult choosing retirement saving over debt reduction pays more on debt servicing, invariably falls behind on other bills, pays higher costs on all future loans, and often raids their retirement plan paying taxes and penalties.

Potential Modifications to Student Loans

Introduction:

The current cohort of students is entering the workforce with substantially more debt than the previous cohorts of student and the growth of both the number of people with student debt and the average debt level have been consistently upwards. High student debt burdens are leading many student borrowers to forgo saving for retirement, delay starting a family, or put off purchasing a home.

Some Democrats have urged President Biden to cancel up to $50,000 in student debt for all people with student loans. Most economists believe that a widespread cancellation of student debt would be an inefficient and regressive subsidy. Many student borrowers with debt could repay their loan without financial assistance and an indiscriminate loan relief program would allocate resources away from other pressing concerns. Most economic analysis supports the view that indiscriminate student debt cancellation programs would do very little to stimulate the economy.

Several papers including one by the New America Foundation one discussed in Inside Higher Education and my own work published by NASFAA have focused on reforming Income Driven Repayment Plans. Current Income Driven Repayment (IDR) programs offering debt relief and linking debt payments to income have many problems.

The programs may incentivize some students to increase the amount they borrow.
Some students that commit themselves to an income linked loan may have been better off with a traditional loan.
Some student borrowers enrolled in IDR programs struggle to meet other financial priorities despite the benefits of the programs.
A large portion of applications for loan discharge have been rejected by the Department of Education as discussed in this CNBC article.

The memo presented here discusses ways to provide meaningful debt relief through modification of standard loan agreements instead of expansion of IDR loans or the creation of indiscriminate loan discharges.

A Proposal:

Discharge 40 percent of the initial loan balance after receipt of 60 monthly payments on 10-year loans and 72 monthly payments on 20-year loans.
Encourage partial interest payments for people in economic hardship rather than total payment forbearance.
Eliminate Interest charges on all loans on the scheduled loan maturity date.
Allow and facilitate collection of outstanding student loans after maturity of the loan by the IRs through federal tax returns.

Benefits of the Proposal:

The proposal presented here eliminates many of the uncertainties and problems associated with current programs offering student borrowers debt relief. It offers students some assistance early in their careers allowing households to save for other priorities. It does not create an incentive for students to increase the amount they borrow and contains incentives to facilitate quicker repayment of student debt. The partial discharge of debt and the elimination of interest charges should reduce the number of people entering retirement with outstanding student debt.

The current system does not provide any loan forgiveness for 10 or 20 years. The earlier debt relief in this proposal allows borrowers to pursue other financial objectives and may facilitate refinancing to lower-interest rate loans.

Many borrowers are unaware of any problems with their loan for 10 or 20 years when they apply for loan forgiveness. The revised program will uncover problems with loan forgiveness applications after 60 months of payments for 10-year loans and 72 months of payments for 20-year loans.

The current system incentivizes many borrowers to pick the IDR program as soon as they leave school even though this choice can lead to higher lifetime loan payments if circumstances change. The revised program assists borrowers with standard loans reducing reliance on IDR loans.

IDR plans create an incentive for some people to borrow more than they otherwise would because they anticipate low life-time loan payments and complete loan forgiveness. The alternative loan forgiveness terms presented here will always result in higher repayments for people who borrow more.

The loan discharge offered in this program occurs earlier for people making all payments on time, creating an incentive for student borrowers to prioritize student loan payments early in their career.

The existence of financial assistance for student borrowers with 10-year loans will reduce an incentive for borrowers to take out long-term loans and will speed repayment to the Treasury.

One study found the number of American over 60 with outstanding student debt quadrupled between 2005 and 2015. The elimination of interest charges at loan maturity proposed here should reverse this trend.

The elimination of all interest at the loan maturity creates an incentive for borrowers to allocate payments to other debts charging interest. This problem is mitigated by requiring a minimum payment on student debt outstanding after the loan matures collected by the IRS through the federal tax return.

Concluding Thoughts:

Student debt is creating financial hardships for many borrowers and existing IDR programs often fail to provide meaningful debt relief. Problems associated with student debt will worsen because of the growth of debt. Most student borrowers can repay and manage their student debt with limited financial assistance. An indiscriminate large discharge of student debt would impose costs on taxpayers and divert funds from other pressing priorities.

The program outlined here provides limited quick and efficient debt relief to student borrowers without the distortions caused by existing programs or proposed large-scale debt discharge proposals.

Financial Priorities for New Entrants to the Workforce

Students entering the workforce tend to have high expenses and relatively modest income.
Young adults need to prioritize the establishment of a good credit rating, the creation of an emergency fund, and investments in their job search.
Contributions to 401(k) plans can wait.
A strategy of rapid reduction of student debt immediately upon entering the workforce will substantially improve credit scores and borrowing costs and reduce lifetime student loan repayments, by tens of thousands of dollars.
Student borrowers with low-cost federal loans and higher cost private loans should prioritize repayment of the high-cost loan. It may be possible to refinance the federal debt once the private loan is eliminated, further reducing lifetime student loan payments.
The rapid repayment of student loan debt can lead to increased contributions to retirement plans once some or all student debt is eliminated.

Many financial planners and firms with solid reputations urge new entrants to the workforce to start their career by aggressively contributing to their 401(k) plan and saving for retirement. Fidelity, a leading investment firm, recommends young adults have a 401(k) balance equal to their annual salary by the time they are 30.

My view is that this objective is unrealistic for the vast majority of young adults entering the workforce with limited liquidity and substantial debt.

My financial advice to young adults entering the workforce can be summarized in three tips – (1) maintain a solid credit rating, (2) create an emergency fund, and (3) rapidly reduce student debt to a manageable level. The achievement of these goals often requires that student borrowers entering the workforce either entirely forego contributions to their 401(k) plan during their first few years in the workforce or at least substantially reduce contributions for some time.

The importance of an emergency fund and a solid credit rating:

The first few years after a person completes school and starts a career are often financially challenging. People leaving school often starts their job search with limited funds in the bank. Starting salaries are often lower than expected and relatively few students immediately get their dream job. The process of searching for a good job is expensive and time consuming. The successful job candidate often has some moving expenses.

Student debt repayment obligations generally start 9 months after full-time student status ends. Moreover, the proportion of students with subsidized federal loans has fallen. The increased use of unsubsidized federal loans and private student loans has increased interest costs on student debt early in the borrower’s career.

Contributions to a 401(k) plan should be an extremely low priority for a person starting a career with a low starting salary, in full search mode for a better job, without substantial savings and with immediate student debt obligations.

The financial planner will tell the financially strapped person with no funds to take the employer match on 401(k) contributions because it is “free money.” Employer matches to 401(k) contributions are not free money if the diversion of money from current needs results in late payments and a deterioration of the person’s credit rating

The highest, perhaps only, financial priority of the new entrant into the workforce is to build a financial buffer in order to maintain a solid credit rating.

The failure to maintain a good credit rating will lead to extremely high costs for borrowers.

A search was conducted for likely interest rates for good and poor credit risks for four different types of loans – (1) credit card loans, (2) car loans, (3) a private student loan, and (4) a mortgage. Assumptions were made on the likely maturity and initial balance of each loan and these assumptions were used to generate estimates of the monthly cost of bad credit.

The interest rate assumption was obtained from WalletHub, the car loan assumption was obtained from Nerd Wallet, the private student loan assumption was obtained from Investopedia, and the mortgage rate assumption was obtained from this CNBC article. The differential between interest rates on people with good and bad were 9.8 points for credit card debt, 7.0 points car loans, 10.0 points for private student loans, and 1.6 points for mortgage debt.

The cost of bad credit depended on both the interest rate differential and the likely loan amount. The analysis presented here assumes a likely loan balance of $10,000 for credit cards, $15,000 for a car loan, $20,000 for a private student loan, and $300,000 for a mortgage.

The analysis assumed the borrower only paid interest on credit card debt. Assumed maturities were 60 months for car loans, 240 months for private student loans, and 360 months for mortgages.

Based on these assumptions, I found the monthly cost of bad credit was $82 for credit cards, $49 for car loans, $124 for private student loans, and $277 for mortgages.

The figures presented here show bad credit ratings can lead to substantial costs with costs depending on both interest differential and loan amounts. The interest differential stemming from credit ratings is highest for credit card loans and private student loans.

The payment differential associated with credit ratings is often highest for mortgage debt because mortgage loans are large. In today’s housing market with soaring home prices and tighter lending standards it is very difficult to purchase a home without good credit.

The cost of bad credit is not limited to one or even a few loans. Most people take out multiple consumer loans or mortgages in their lifetime. The lifetime cost of bad credit will be substantial for households that do not improve their credit rating.

Poor credit ratings have other adverse impacts in addition to higher loan costs. The Insurance Information Institute points out the insurance companies use credit ratings to set insurance premiums because actuarial studies have shown that credit scores are good predictors of the tendency for people to make insurance claims. The credit rating agency Experian points out that employers can and sometimes do base hiring decisions on an applicant’s credit history. Landlords use credit ratings to determine eligibility for an apartment.

The Importance of Rapid Student Debt Reductions Early in a Career:

Students leaving school with substantial federal and private student debt should rapidly repay the private student loan even if the rapid repayment of the private loan causes them to forego contributions to their 401(k) plan.

The rapid reduction after joining the workforce will drastically reduce lifetime student debt borrowing costs. Rapid debt reduction may make it possible for the student borrower to refinance remaining debt at a lower interest.

Finance companies often attempt to persuade student borrowers to refinance their federal student loans to lower-interest rate private loans. This article provides recommendations from CNBC on the best companies for refinancing student debt.

Often student borrowers cannot refinance to a substantially lower interest rate immediately upon graduation because their work and credit history is short, and their initial salary is low. A student borrower could improve their credit report by foregoing 401(k) contributions for a year or two and then refinance the remaining student loan at a lower interest rate.

There are advantages and disadvantages associated with refinancing federal loans to private loans. The primary advantage is a lower interest rate, perhaps as low as 3.0%. You must be careful when refinancing a fixed rate student loan to a variable rate loan because the student loan interest rate can rise substantially if Treasury rates rise. In addition, the decision to refinance with a private student loan makes the borrower ineligible for forbearances in case of economic hardship and makes the borrower ineligible for income driven loan programs

The potential financial gains from a strategy of rapidly reducing student debt upon entering the workforce are examined for two student borrowers – one with a large federal undergraduate loan and the other with a mix of federal undergraduate and graduate loans and a private loan.

Student Borrower Number One: The first student borrow is starting her career with a $50,000 per year job and undergraduate student loans totally $30,000 with an interest rate of 5.05% around the 2019 average student debt level for undergraduates.

A person in this situation will typically take out a 20-year student loan. Her payments on the loan will $198.82 per month. Her total payment over 20 years will be $47,716.

The person could more rapidly repay her student loan if she foregoes contribution to her 401(k) plan. Assume she currently pays 10 percent of her income to her 401(k) plan. If she foregoes this contribution her annual income tax will increase by $600. However, she could increase payments on her 401(k) plan by $4,400 per year to a total monthly payment of $565.48.

Under this assumption the student borrower would totally repay her $30,000 student loan on the 61^stpayment. Her total student loan repayment costs would be $33,837, a savings of $13,879.

The strategy of rapidly repaying the student loan causes the student borrower to fall behind on her accumulation of 401(k) wealth. However, her student loan is totally paid off after 61 months and she could now make larger 401(k) contributions than the person who immediately initiated 401(k) contributions after leaving school.

The student borrower in this example could forego 401(k) contributions and make monthly payments of $565.48 for two years and then attempt to refinance the loan at a lower interest rate for a 10-year period.

The outstanding balance after two years of payments would be $18,932.

The person after reducing the loan balance that quickly might be able to refinance at a 3.0% interest rate. The total student debt payments from this strategy, rapid repayment for two years followed by a 10-year loan at 3.0%, is $35,509 or $12,207 less than under a 20-year term.

The rapid reduction of student debt will lower the probability the person experiences debt payment problems and will substantially reduce expenditures on student debt.

The results are even more dramatic for a student borrow that has a combination of federal debt and high-rate private loans.

Student Borrower Number Two: The second borrower has three student loans, a $35,000 undergraduate loan at 5.05%, a $40,000 graduate loan at 6.66% and a $25,000 private student loan at 10.00%. Intuitively, it makes sense for this student borrower to prioritize rapid repayment of the higher interest rate private loan. In most instances, the strategy of rapidly repaying the private student loan necessitates the borrower forgoing contributions to a 401(k) plan early in her career.

The student borrower who chooses to set the standard 20-year maturity on all three student loans has a monthly payment of $775 for 20 years leading to total student loan payments of $200,633 over 20 years.

The student borrower who chooses to set the standard 20-year maturity for the federal undergraduate and the federal graduate loan and set a 5-year term for the private loan will initially have monthly student loan payments of $1,065.

The monthly payment will fall to $534 after the private student loan is totally repaid, which is lower than the $775 payment that exists if the person kept to a 20-year term on all loans. This means the person who chose the rapid private student loan repayment strategy could after 5 years make larger 401(k) contributions for the next 15 years than the person who chose a 20-year private loan term.

The total lifetime student loan debt payments for the person who repaid her private student loan in 5 years instead of 20 years is $146,271, which is a total lifetime savings of $54,362.

This student borrower is in a good position to refinance her federal student debt to a private lower interest rate loan after repaying her private loan. The cost savings estimates presented here may understate potential benefits from a strategy of rapidly reducing private student debt.

Concluding Thoughts: The student borrower entering the workforce is often under intense pressure from financial advisors to immediately contribute part of their salary to a retirement account. This approach can lead to financial disaster.

The young adult with a modest salary and high student debt payments who prioritizes saving for retirement can fall behind on her bills, which can lead to poor credit ratings. The deterioration in credit ratings will lead to high borrowing costs and other problems including difficulties renting an apartment, loss of job offers and higher insurance costs.

Eventually, many people who choose to aggressively save for retirement will raid their 401(k) and maybe even sometimes pay taxes and penalties. Increasingly, young and middle-aged adults are tapping 401(k) funds prior to retirement to meet current needs. A CNBC article reveals that nearly 60 percent of young workers have taken funds out of their 401(k) plan

The wiser course of action for young adults entering the workforce saddled with student debt is to rapidly repay student loans, especially but not exclusively high-cost private loans. This approach will secure a solid credit rating and will reduce lifetime student loan payments by tens of thousands of dollars.

This post is part of a series comparing the traditional financial plan, stressing 401(k) investments and house purchases with 30-year mortgages to an alternative financial plan, which prioritized debt reduction, use of Roth accounts and use of 15-year mortgages. The first post provided an overview of the alternative financial plan. The next post, available in a week or so, will look at some problems with conventional retirement accounts starting with high fees on some plans.

Outline of an Alternative Financial Plan for the New Generation

Traditional financial strategies, which prioritize accumulation of wealth in a conventional retirement plan, as soon as people enter the workforce are not working for many households.
The alternative financial strategy outlined here involving — aggressive elimination of student debt, greater use of 15-year mortgages, the use of Roth retirement accounts instead of conventional accounts, and additional investments outside of retirement accounts — will reduce financial stress and lead to a more secure retirement than the traditional financial plan.

Many households are struggling with historic levels of debt.

Average student debt for college graduates in 2019 was 26 percent higher in 2019 than 2009. Around half of bachelor’s degree recipients in 1992-1993 borrowed to finance their education, compared to around 65 percent today.

Increasingly, young and middle-aged adults are tapping 401(k) funds prior to retirement to meet current needs. A CNBC article reveals that nearly 60 percent of young workers have taken funds out of their 401(k) plan. A study by the Employment Benefit Research Institute (EBRI) reveals that 40 percent of terminated participants elect to prematurely takeout 15 percent of plan assets. A poll of the Boston Research Group found 22 percent of people leaving their job cashed out their 401(k) plan intending to spend the funds.

Statistics presented in a recent Business Economics article show that people who tap 401(k) plans prior to retirement were more likely to have taken out consumer loans, were more likely to have a poor credit rating and were more likely to be underwater on their mortgage than people who did not tap their 410(k) plans prior to retirement.

A CNBC portrayal of the financial status of millennials nearing the age of 40 found many members of the age cohort highly leveraged struggling to pay down student debt, using innovative ways to obtain a down payment on a home and barely able to meet monthly mortgage payments.

A 2019 Congressional Research Service Report found that the percent of elderly with debt rose from 38% in 1989 to 61% in 2021. The Urban Institute reported that the percent of people 65 and over with a mortgage rose from 21% in 1989 to 41% in 2019. A 2017 report by the Consumer Finance Protection Board found that the number of seniors with student debt increased from 700,000 to 2.8 million over the decade.

The standard financial plan, proposed by most financial advisors, emphasizing large contributions to traditional 401(k) plans instead of aggressive reduction of consumer and mortgage debt often fails to provide a secure financial outcome. Future outcomes will be worse, barring a change in strategy in financial strategy, because people are starting their careers with higher debt burdens.

The aggressive pursuit of long-term investments in stocks and bonds instead of rapid reduction in debt is especially problematic in the current market environment where stock valuations are stretched, and interest rates are at historic lows. The purchase of expensive securities inevitably leads to subpar returns when valuations return to more normal levels.

The alternative financial strategy proposed here differs from the traditional financial strategy in four important respects.

First, the alternative approach prioritizes the establishment of a solid credit rating, the creation of an emergency fund and the rapid reduction of student debt for individuals leaving school and entering the workforce. The achievement of these goals usually requires new entrants to the workforce delay or reduce 401(k) contributions for a number of years when starting their careers.

Second, the alternative financial strategy places a high priority on the growth of house equity and the elimination of all mortgage debt prior to retirement.

Many households with less than stellar credit purchase a home with a subprime mortgage. Subprime mortgages tend to have high interest rates, adjustable rates with short adjustment periods, a balloon payment, and restrictions on prepayments. The alternative financial strategy opposes the purchase of a home with an unfavorable interest rate or subprime features.

Most households currently use a 30-year fixed rate mortgage. The alternative financial strategy recommends the use of 15-year mortgages, either through the original home purchase or through a refinancing, to reduce lifetime mortgage payments and to accelerate growth in house equity.

Many financial advisors currently recommend additional catch-up payments to 401(k) plans for workers nearing retirement even when the worker will retain a mortgage in retirement. The alternative financial strategy prioritizes mortgage payoffs over additional 401(k) contributions.

Third, the alternative financial strategy utilizes Roth retirement accounts instead of conventional retirement accounts.

The decision to use Roth rather than conventional retirement accounts can increase tax burdens in working years; however, there are multiple other ways for working-age households to reduce current tax obligations. In particular, contributions to health saving accounts linked to high-deductible health plans reduce current-year tax obligations, reduce insurance premiums and like retirement accounts increase income during retirement.

The use of Roth rather than conventional retirement accounts directly reduces tax obligations in retirement, reduces the marginal tax rate for people with other sources of income and indirectly reduces tax on Social Security benefits for some households.

The use of Roth rather than conventional retirement accounts reduces the amount of money a person must park in stocks inside a retirement account because the investor no longer needs to save for taxes on disbursements. The lower taxes from use of Roth accounts reduces financial exposure to market downturns.

Retirement account fees will be lower on Roth accounts because the total annual fee is a percent of total invested assets, which is lower because tax on Roth accounts is paid prior to contributions.

The use of Roth rather than conventional retirement accounts will substantially reduce tax on inherited IRAs. This savings is larger today because of recent changes in tax rules governing inherited IRAs.

Fourth, the alternative financial strategy makes greater use of investments outside of retirement accounts including investments in stocks and investments in inflation linked bonds.

Retirement accounts are an effective way to defer taxes until retirement. However, the existence of assets outside a retirement account reduces tax obligations during retirement years.

Disbursements from conventional retirement accounts are taxed as ordinary income while taxes on capital gains and dividends are currently taxed at preferential rates. (The tax preferences for capital gains and dividends may be reduced by the Biden tax plan.)

The availability of funds outside a retirement account are especially important when retirement accounts have high annual fees and interest rates are low. The effective interest on some bonds held in retirement accounts is negative when the retirement account has a high annual fee.

There are no fees associated with the purchase bonds directly from the U.S. Treasury. These bonds have relatively low market risk. The purchase of Treasury bonds with specific maturity dates is an effective way to hedge against market down turns impacting consumption during retirement.

The traditional approach to retirement often centers on the question – How much money should be placed in a 401(k) plan in order for you to retire? There are even calculators that create estimates of the amount people need to place in a 401(k) to retire with adequate income.

The actual amount of wealth you need to place in your retirement account is indeterminate. The amount you need to save depends on several factors including whether the retirement account is Roth or conventional, retirement account fees, amount of debt, whether you plan to downsize, the quality of your health insurance and the tax status of assets outside your retirement account.

The alternative financial strategy outlined in this introductory memo recognizes that financial security cannot be summarized by the dollar value of a 401(k) plan. A person with large net worth dominated by large equity holdings in a conventional 401(k) plan is faced with large future tax obligations and is perpetually exposed to a market downturn, especially if she has a monthly mortgage bill to meet. The person could be better off with a lower 401(k) balance if she had paid off her mortgage, put money in a Roth rather than a conventional retirement account, and purchased some inflation-indexed bonds.

Several features of the alternative plan presented here will reduce the amount that you must contribute to a retirement plan and the amount you pay over your lifetime in retirement plan fees. Fees charge by retirement accounts are not a trivial matter. This report by the Center for American Progress reveals a median-wage worker might pay $138,000 in retirement fees over her lifetime.

The traditional goal of financial planners is the construction of a portfolio that will allow retirees to initially distribute 4 percent of the 401(k) balance and maintain that distribution level though out retirement. The 4 percent rule often fails to provide a sustainable level of consumption in retirement with the largest failures occurring when portfolios are closely tied to the market and the market takes a downturn early in retirement.

Some financial advisors advocate a more flexible distribution rule that mandates reductions in distributions during market downturns. It seems as though a strategy calling for sharp reductions in distributions during retirement is an admission that the financial strategy planning for retirement was a failure. An alternative financial strategy which includes alternative investment including, I-Bonds, E-Bonds and perhaps annuities, will lead to more stable consumption patterns in retirement. The alternative financial strategy would include a more stable and sustainable rule determining monthly distributions of funds.

The upcoming blog posts presented here and a larger formal paper will describe the potential benefits of the alternative financial strategy in greater detail. A detailed discussion on how to best rapidly reduce student debt and the potential advantages of the debt elimination strategy will be available at this blog soon.

The Politics of Student Debt

There are two distinct lanes in the Democratic party. The progressive lane gravitates towards big ideas, which if implemented would transform society and the economy. The centrist land proposes modest changes to existing programs, which often would not substantially change the status quo. Most of the focus of the political discussion centers on the big proposals offered by participants in the progressive lane often leading to their rejection. Proposals offered in the centrist lane receive much less scrutiny. Problems and limitations of centrist proposals are often ignored.

The debate among candidates on student debt closely follows this pattern. The progressive lane advocates for free college and for immediate and substantial debt forgiveness for all or almost all people currently with student debt. The centrist lane advocates additional assistance for community college, and expansion of existing programs including Pell grants, Income Driven Loans, and Public Service Loans. The discussion centers on the economic and political feasibility of proposals offered by the progressive lane and does not consider the adequacy or potential problems with solutions offered by centrists.

An objective analysis of the progressive agenda suggests that its enactment requires a complete transformation of the U.S. economic, political, education, and tax systems. The consensus from this discussion is that a solution that works in a high-tax high-regulation European economy cannot be easily or quickly transferred to the United States. Moreover, many people argue that large subsidies for student borrowers are unfair to workers and taxpayers who do not attend school and are unfair to previous cohorts of student borrowers who paid off their student debt.

Centrist plans for making college more affordable and alleviating student debt burdens get far less scrutiny than progressive plans. In recent decades, there has been a substantial increase in the number of student borrowers, average student debt and the number of people entering retirement years with outstanding student loans. Centrist proposals, while more generous than policies espoused by the Trump Administration, are unlikely to reverse these trends.

A major education policy goal for many politicians in the centrist lane is on assuring an adequate supply of workers in hard to fill positions. Klobuchar in her New York Times interview on education spoke about the lack of shortage for MBAs or CEOs and the need to fill positions for home health care workers. The financial incentives in her proposals and the proposals offered by other centrists would steer many students away from academic four-year colleges towards two-year schools emphasizing practical career choices. The argument that people with substantial talent need to gravitate towards practical career choices early in their life because of economic reality is not highly inspirational or consistent with the view that education can lead to upward mobility.

The emphasis on education for practical positions leads centrists to support substantial increases in funds for community colleges. A policy that decreases the relative price of community college to four-year college could lead to fewer students from low-income households at four-year colleges. This approach could create a two-track academic structure where students from low-income households are slotted towards community college and students from households with more financial resources are slotted towards more prestigious four-year institutions. The student from the low-income and mid-income household may have enough talent to become a CEO or an MBA or a doctor. It is not clear whether the increased emphasis on community colleges will keep these doors open.

The centrist plan also includes increases in the budget for Pell grants. Pell grants target relatively low-income households and would have a relatively small impact on student debt for the typical student borrower. It would be extremely difficult and expensive to expand the Pell grant program to reduce debt burdens on students from middle-income households. Funds for Pell grants are part of the annual budget and subject to the whims of Congress.

Two additional ways to assist students from low-income households deserve consideration.

The first method involves free tuition or substantially reduced costs for the first year of four-year colleges. A free first year of college would decrease student debt for all student borrowers. Benefits would be especially large for students who fail to ever complete their degrees or students who take a long period of time to graduate, two populations that often experience repayment problems.

A free first year of college would allow for private grant funds to be allocated across a smaller population. (First year students would theoretically not need private grants if the first year was free.) An increase in grant funds per student after the first year of college would further reduce student debt burdens.

The second method involves the creation of additional two-year degrees at major four-year institutions. This approach allows more students access to major universities. The availability of more two-year degrees at four-year colleges could reduce the number of people who leave school without a degree. There may also be some students ready for graduate school after two years of undergraduate work.

The debate over debt relief options also centers on extremely ambitious proposals offered by candidates in the progressive lane. Less attention is focused on options favored by candidates in the centrist lane including the expansion of income driven loan programs and the Public Service Loan Forgiveness program.

A proposal offered by Senator Warren would discharge $50,000 of student debt for people with income less than $100,000 and a reduced amount of debt relief for borrowers with income above that threshold. Senator Sanders has offered universal discharge of student debt for student borrowers.

These broad debt relief programs are not economically efficient because they divert scarce resources away from more pressing problems. Many of the student borrowers who would receive assistance under these proposals are able to repay their loans without government assistance. The proposals are also unfair to workers who don’t benefit from higher education and to previous students who repaid their loans.

The candidates in the centrist lane favor expanding Income Driven Loan programs and the Public Service Loan Forgiveness programs. There are major problems with loan programs that link student loan payments to income and programs that offer debt relief for public service. However, problems with these programs and potential improvements are barely addressed because all of the attention is focused on the more ambitious progressive proposals.

Income Driven Loan programs link loan payments to annual income and allow for the possibility of loan discharges after a number of years. There are many problems with this approach. Student borrowers must choose to enter an Income Driven Loan program or remain in a conventional loans program when leaving school. Whether a student borrower is better off under an Income Driven Loan program or a conventional loan program depends on income and marital status over the lifetime of the loan and is often impossible to predict when students make their loan selection.

Moreover, student borrowers must reenroll annually in income driven loan programs. Errors by loan services could result in the denial of loan discharge applications for some student borrowers. The loan discharge is contingent on student borrowers making 240 on-time loan payments. Income driven loan programs may fail to provide debt relief to student borrowers who fail to make payments because of financial hardship. This is the group most in need of assistance.

The Public Service Loan Forgiveness program does not have a great track record. The program makes loan discharges contingent on an applicant staying in a public service position for 10 years. Some applicants lose debt relief when they switch careers. Over 99 percent of people in the first cohort of applicants to apply for a loan discharge under the Public Service Loan Forgiveness program had their discharge applications denied, even though the applicant had made loan payments for 10 years. There are several reasons for the large rejection rate on loan discharge applications. Some applicants were informed that they were employed at firms in positions, which were not eligible for the public service loan program. Some applicants were informed after 10 years or payments they had chosen a payment plan that was not consistent with the public service loan forgiveness program. Problems involved with administering the public service loan program are documented in this report written by the Consumer Finance Protection Board.

There are superior alternatives to Income Driven Loan programs and Public Service Loan Forgiveness programs that are not even currently being considered.

A provision in a loan contract eliminating interest charges near the end of the loan term would be simpler to administer and fairer to both borrowers and the taxpayer than a program offering loan discharges after 20 year of payments. A loan discharge provision creates an incentive for some students to increase the amount they borrow and discourage quick repayment of student debt. Students with a loan that allows interest rate reductions near the end of the loan term will always repay more if they borrow more and are not discouraged from entering a short- term payment plan.

The elimination of interest near the end of the loan term also offers some debt relief to student borrowers who miss payments and are ineligible for a loan discharge.

The Trump Administration and Congress propose to eliminate the Public Service Loan Forgiveness program because of its cost to taxpayers. In order to obtain debt relief from a public service loan program, applicants must stay in a public service career for 10 years. Some applicants may choose to eschew more productive positions to obtain a debt discharge.

A narrower Public Service Loan Forgiveness program that provided less debt relief for a short period of time when student borrower begin repayment could increase loan repayments when people are starting their careers and salaries are relatively low. This program would be easier to administer and less expensive than the current Public Service Loan Forgiveness program. More importantly, the revised shorter-term benefit would not create job lock.

The discussion and the energy in the Democratic party revolves around support for or opposition to big ideas. The potential and problems associated with modest proposals are not fully evaluated. Not surprisingly, this debate is not leading to the formation of practical policies that would actually reduce student debt burdens. We need a third lane offering pragmatic progressive policies, which could lead to real change.