A discouraging part of being married to a dentist with a strong interest in personal finance is that I come across articles from time to time about the massive debt and resulting hopelessness for many new grads. When reviewing the statistics, the outlook can look pretty bleak and the opinions rather sensational.
Dental school is nearly impossible to pay off.
Without income driven repayment options, default rates for dentists will balloon.
We know firsthand the sticker shock when it comes time to make those first payments. At last count, my wife and I still owe over $380k in student loans – a great majority of that amount coming from the high cost of a private dental school education.
As such a viable alternative, it’s easy to see the allure of income based repayment plans. After all, how is someone with hundreds of thousands of dollars in student loan debt supposed to pay their loans on a starting salary in the low six figures, let alone take on other debts such as buying a home and/or a practice?
That’s the feeling.
But is it true?
Without assistance, the debt loads needed to complete dental school and other professional programs can at first glance seem insurmountable. As a student, you can anticipate how your life will look and what decisions you’ll make once you start earning something, but it’s hard to fully comprehend until those first paychecks come in and the loan payments and other bills start going out.
It’s especially difficult when the loan payments are for sums of money that far exceed what a pair of twenty-somethings have ever encountered seeing as they’ve only ever known the incomes and expenses of a couple college students. It’s an order of magnitude change, and you need a second to get used to the new normal.
Our current overall debt to income ratio is well above 1. Not long ago, it was well over 2. In other words, our student loan debt was more than twice as high as our gross annual income. By those standards, we would have easily qualified for one of the many income driven repayment plans such is IBR, PAYE, etc.
Starting on one of these plans would have drastically reduced our loan payments. An added benefit, the proponents say, is the potential of loan forgiveness should you stay on this plan for a few decades should you still have a balance remaining.
Some would argue that someone with our level of debt needs income based repayment.
While that may be true, it’s not necessarily true.
The reason is that not all debt to income ratios are created equal. In our case, regardless of how the metrics are defined, my wife and I are not currently, nor have we ever faced financial hardship that would necessitate the need for income driven repayment.
Simply put, our income is sufficient to handle our level of debt payments and all other spending.
Proportionality of Income and Spending
Let’s dispel the idea that expenses are proportional to income (which discretionary income as a fraction of your income to qualify for income driven programs suggests). For a fixed level of spending, one’s ability to pay down debts increases as income increases. Pretty straight forward, right?
So, with that, I ask the following: If your debt to income ratio was to be a fixed number greater than one, and you could choose any level of income, how much would you choose to make (and owe)?
Let’s consider two families that each have a debt to income ratio of 2 and each has $75,000 in living expenses excluding the cost of their student loans. Family One has a combined taxable income of $150,000 (and student loan debt of $300,000) while Family Two has a taxable income of $200,000 (and SL debt of $400,000).
After considering federal taxes, Medicare, and social security on their $150,000 gross salary, Family One is left with just under $110,000 to live on and make student loan payments. After $75,000 living expenses are considered, the family is left with just under $36,000 to apply towards student loans. At a monthly payment of just under $3,000, it would take roughly 12.4 years to pay back the $300,000 assuming student loans at 6.8%.
Family Two on the other hand is left with over $146,000 after taxes on their $200,000 gross income, and over $71,000 to cover student loans after taking $75,000 to cover the families living expenses. By being able to afford a payment of over $5,900 ($71,000/12), even though they owe $100,000 more, it allows them to pay their loans off over 40% faster, by only taking ~7.1 years.
So even with the same debt to income ratio, Family Two is able to pay down their loans over five years faster than Family One just because they didn’t inflate their lifestyle and have more money to pay towards their loans, even though they initially owe $100,000 more.
Clearly, more than debt to income needs to be considered when determining whether or not a debt payment is sustainable.
Sustainable Debt to Income Ratio
Let’s now consider debt to income ratio on a standard 10 year repayment plan (assuming 6.8% interest) as a function of household income for various spending levels:
The debt to income ratio that you can afford to make 10 year standard repayment at fixed 6.8% interest rates for varying levels of (non-student loan) spending.
As (non-loan) spending increases, the gross income required to just break-even also increases. Beyond that, however, the debt to income ratio that a borrower can repay on a standard 10-year repayment plan increases provided living expenses remain constant.
The conclusion I draw from this is that simply looking at student loan debt to income ratios tell you next to nothing about whether a borrower can reasonably expect to make their payments if you don’t also have the context of income and spending levels.
So what if you can’t relate to the above examples? Perhaps your income or spending limits your ability to set up a standard repayment schedule. In that case, you may be a good candidate for income driven repayment plans. There are other options as well.
As described in our post about how we’re paying off over $500,000 in student loan debt, we described other strategies including private refinancing and extending loan terms. We were fortunate to be able to refinance over $400,000 in student loan debt and cut our interest rates in half, dropping our interest charges by over $1,000 each month.
This post wasn’t meant to be an argument for avoiding income driven repayment plans. Nor should it be considered a recommendation for any particular repayment strategy. Rather, the intent was to make an attempt to quantify whether a borrower needs an income based plan to avoid financial distress or worse by looking at three variables: income, debt, and expenses.
My wife and I plan to reach financial independence by age 40. In spite of our absurdly high level of student loan debt, we’re fortunate to have relatively high income levels in our favor. Because of this, we don’t envision a scenario where we plan on early retirement and also feel the need for an income repayment plan, even if it would be financially advantageous for us to do so.
As we’ve said before, we knew what we were signing up for when we took on this much student loan debt and we are focused on paying back what we promised to, because we are able to.