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Financial Literacy Building Block: Compound Interest

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financial literacy building blocksAlbert Einstein said compound interest is the 8th wonder of the world.

Those who understand it, earn it.  He who doesn’t, pays it.

In other word, it’s a double edged sword.

Terrific if you’re earning it.  Debilitating if you’re paying it.

And compound interest is a fundamental building block of personal financial literacy.

Why compound interest matters

Understand compound interest, and you’re motivated to contribute to your IRA faithfully.  The interest your account earns this year itself earns interest next year.  And next year, and the next,

Borrow money at compound interest and the interest bearing balance can grow to be larger than the original loan.

Compound interest is at the heart of many of the student loan horror stories.  Student borrows $10,000, uses some deferments,  and, after paying for years, owes $18,000.

How does that work?

Deferred student loan payments compound

The interest portion of a deferred payment is added to the loan balance, and that unpaid interest accrues more interest.

Student loan servicer Navient explains it this way.

Unpaid accrued interest is added to the principal amount of your loan after you leave school and finish any applicable grace period. Simply put, there will be interest to be paid on both the principal of the loan and on the interest that has already accumulated.

Sallie Mae uses slightly different language.  They talk about “capitalization”.  Different words, same idea.

“Capitalized” means added to the Current Principal of the loan.  Your billing statement might show a Current Principal that’s more than the original amount that you borrowed. That’s because the interest has been accruing since the loan was originally disbursed. The more frequently interest is added to the Current Principal, the more interest you will pay. Capitalization may occur when the separation or grace period ends, or at the end of a period of forbearance or deferment.

So, that comforting deferment of your payment obligation has you suffering the downside of compound interest.

Reverse mortgage sucks equity

At the other end of the age spectrum, homeowners taking out a reverse mortgage suffer compound interest on their loan.

The money you draw out incurs interest, which you don’t pay under the terms of the mortgage.  However, that unpaid interest is added to the loan balance of the reverse mortgage.

Next accounting period, you’re incurring interest on the interest you didn’t pay before.

Equity shrinks fast at that rate.

Einstein got it:  Fail to pay according to terms and the debt grows even faster than at simple interest.

Compound interest fuels savings

If you are the saver, rather than the borrower, compound interest works great.

The interest your savings earn this year earns more interest next year.

Suppose you save $100 a month and it earns 3% interest.  At the end of 10 years, you have $15,782.

That’s $3782 in interest, even at today’s paltry interest rates.

Same rate of savings over 30 years gets you $25,716 in interest, swelling your nest egg.

Personally, I’d rather be earning compound interest than paying it.  You?

 

The Killer Rule That Zaps Private Student Loans

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Got private student loans?

I’ve got good news and bad news.

Bad news first.

Private Student Loans Inflexible

Private student loans have no built in mechanisms for deferment and forbearances, like government-backed loans do.

There are no income based repayment plans, as there are with federal student loans.’  No “outs” for disability or schools that close and leave you stranded.

No discharge in bankruptcy.

So, regardless of what life hands you, you have to pay according to the terms of the note.

But I promised you some good news.

Private Student Loans Must Play By The Rules

The promising news is that private student loans are hardy different in the eyes of the law than credit cards.  That makes them subject to all the rules about collection that apply to any other debt.

One of those rules is timeliness.  Lawyers call it the statute of limitations.

The rule essentially says that a creditor who isn’t being paid must sue within a fixed period, or lose the right to use the courts to enforce its debt.

The statute of limitations doesn’t prevent a debt collector for a private student loan lender from using all the usual tools of collection:  fear, shame, and annoyance.

It just means they can’t win in court.  Or, more precisely, they can’t win if you show up in court and assert the statute of limitations. [Read more…]

Can You Be Arrested For Not Paying Your Debts?

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jail-983153_640Despite the story spread all over about federal marshals arresting a man for an unpaid student loan, we don’t arrest people for not paying their debts.

And Fox News got the story wrong.  The man was not arrested because he owed money he hadn’t paid.

He was arrested for blowing off a court order that he appear in court.

Ignore a judge who orders you to show up and bad things happen.

But it’s important to get the story straight.

Had the borrower appeared in court as ordered, he would not have been arrested, whether or not he could pay the judgment.

And the fact that the debt was a student loan didn’t drive the outcome.  It would have been the same if the judgment arose from an unpaid dental bill.

What happens when there’s a judgment

Judgments have consequences.  The man in the story had a judgment entered against him when he failed to pay his student loan. [Read more…]

Congress Considers Making Student Loans Dischargeable in Bankruptcy

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student loan discharge legislation

A newly introduced bill in Congress would make student loans dischargeable in bankruptcy, as they were decades ago.

The bi-partisan bill is sponsored  by  Democrat John Delaney of Maryland and Republican John Katco of New York.

Any change to the law touching discharging student loans is a long way down the pike.  But this is a start.

And start we must when student loan debt debt is $1.4 TRILLION dollars, dwarfing outstanding credit card debt.

That debt suppresses home buying; family formation; and entrepreneurship.

I heard a telling comment from another bankruptcy lawyer testifying to the ABI Commission on Consumer Bankruptcy Law:  how is it that we allow the discharge of income taxes after the passage of time but not student loans?

How?

History of student loan discharge

It’s important to remember that student loans have not always been a life sentence.  In the 80’s, a student loan was dischargeable when it had been in pay-status for 5 years.  In 1990, the pay-period element of dichargeability was extended to 7 years.

That required that the borrower make an effort to pay the loan.

In 1998, the rules changed.  A federally insured student loan could only be discharged if the borrower could prove that repayment constituted “undue hardship”.

As if that wasn’t harsh enough, the amendments of 2005 made privately funded student loans non dischargeable in bankruptcy.

Private student loans are as poisonous a debt as you can image:  made at market rates of interest they ensnare students and their families, without income-based repayment plans or procedures to rehabilitate the loan.

Chinks in the no-discharge armor

Bankruptcy courts in most judicial circuits use the Brunner test to determine if repayment of a student loan debt after bankruptcy would cause an “undue hardship”.

To achieve a bankruptcy discharge of a student loan, the debtor has to the burden to show

“(1) the debtor[s] cannot maintain, based on current income and expenses, a ‘minimal’ standard of living for [themselves and dependents] if forced to repay the loans; (2) that additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period of the student loans; and (3) that the debtor[s have] made good faith efforts to repay the loans.”

The test has acquired levels of interpretation such that discharge requires a showing of efforts to pay and assured, hopeless, unchanging poverty in the future.  That’s what you get, now, for trying to get an education.

Bankruptcy Judge Jim Pappas took up the gauntlet from Judge Easterbrook in challenging whether this hoary test from the 1980’s is properly reflective of bankruptcy law today in a persuasive concurrence in a 9th Circuit BAP case Roth.  Said Judge Pappas

the analysis required by Pena/Brunner to determine the existence of an undue hardship is too narrow, no longer reflects reality, and should be revised by the Ninth Circuit when it has the opportunity to do so. Put simply, in this era, bankruptcy courts should be free to consider the totality of a debtor’s circumstances in deciding whether a discharge of student loan debt for undue hardship is warranted.

Student loan relief in Congress

H.R. 2366 has, undoubtedly, a tortuous path forward in Congress.  But it is a clean, straight-forward approach to a complicated problem.  Without a solution to student loan debt that threatens to crush both students and their parents, it is a vehicle to start the discussion.

Let your representatives in Congress hear from you on the impact of student loan debt on the life of your family, starting here.

More

The Parent Loan Trap

The Public Service Route Out Of Student Loans

Why These Student Loans Got Discharged In Bankruptcy

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student loan dischargeDischarging the student loans of a truck driver who lived in his employer’s truck or in a homeless shelter, the bankruptcy court found that repaying $37,000 in student loans from 20 years ago would be an undue hardship.

Good call, but why does the decision excite?

Student loans do get discharged in bankruptcy, sometimes.  This is not the first.

The  legal test for undue hardship, applied by bankruptcy courts, is harsh and many courts seem to have enhanced the harshness by requiring that the debtor be destitute and utterly without hope of improvement.

I’ve often told clients that you need to be an unemployed paraplegic before some courts will permit the discharge of student loans.  It’s an exaggeration,  but not by much.

So what’s new about the victory of Michael Abney over the U.S. Department of Education?  It’s the practicality of the judge in assessing the life prospects of the borrower. And the factors that the judge used to measure those prospects.

Abney decision

This result stands out from the pack in that the debtor was healthy, middle aged and working. [Read more…]

Get Out From Under Student Loans In Half The Time

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Work full time for a governmental agency or non-profit, and you can discharge your federal student loans after 10 years of payments.

Regardless of the balance.

Tax free.

And regardless of the job you hold in a qualifying employer.

Rich man, poor man,
Beggar man, thief.
Doctor, lawyer,
Indian chief !

Not sure about these job titles from the nursery rhyme, but the student loan forgiveness isn’t confined to the professionals at these agencies.

The IT person, the school janitor , the administrator and the bus driver are equally entitled to a public service loan forgiveness.

It’s easy to know if you work for a governmental agency of some kind, but drawing the line between non profits and 501(c)(3) entities may be harder.

The qualifying employers are those who can accept tax deductible contributions under the Internal Revenue Code.  Luckily, the IRS has a data base that will tell you if an entity is a qualified charity.

Employment doesn’t have to be continuous, either.

You needn’t sign up in advance.  All you need to do is make 120 payments and, as a practical matter, be on a payment plan longer than 10 years.  You apply for forgiveness after you’ve made 120 payments and while working for a qualifying employer.

Talk about poorly known treasures.

More on public service loan forgiveness.

This is just one of the incredibly useful nuggets about helping people with student loan troubles I gleaned from Josh Cohen, rightfully called The Student Loan Lawyer.

 

Image from Storytiming.com

 

Student loans: sinking the parents

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The numbers on repayment of a student loan for four years at a private university are brutal.

No matter how enriching the education, the loan may be the financial death of the graduate.

But what sorrows me is the plight of the parents of those same students who have guaranteed or cosigned those loans.

Cosignor equally liable for loan

The co signor isn’t a second line of recovery that the lender can tap if the borrower doesn’t pay.  The lender can go directly to the co signor for payment.

 

More frightening, the cosignor has no control over whether the loan gets deferred (with interest during deferment added to principal) or whether the student honors the commitment to pay.

On the numbers in Gene Melchionne’s article , you can see in an instant why the student borrower might not be able to pay, even assuming the graduate got a decent job.   The payment on loans for a 4 year private college degree equal the average after tax income of  a new college graduate!

That’s right:  the student loan payment takes ALL of the typical grad’s after-tax income.

Default seems inevitable, and the parents who cosigned are on the hook.

Student loans in bankruptcy

The cosigned loan is a non dischargeable debt should the parents file bankruptcy, without taking any further steps.  To discharge a student loan, you have to file an adversary proceeding in the bankruptcy court and  prove to a judge at trial that repaying the loan as written is an undue hardship.

Historically, the test for undue hardship has been remarkably harsh.  Courts in the 9th Circuit have embraced a middle ground in a non dischargeability cases: partial discharge.

The court can find that repaying all of the loan is an undue hardship, but repaying some part of it is not.  The borrower or cosignor walks out of bankruptcy court with a smaller student loan burden.

I’m seeing a fair number of folks in their late 50’s and 60’s, nearing retirement, or enduring unemployment,with their kid’s student loans a millstone around their neck.

Frankly, I’m waiting for a stalwart couple of a certain age for an opportunity to argue to a bankruptcy judge that repayment of the offspring’s student loans at this point in the parents’ life is an undue hardship.

At least one prominent bankruptcy judge has made the case that the test for measuring undue hardship belongs to a long-gone era of student loans.

In Roth, Judge Pappas put out the argument that the Brunner test’s harshness could be understood when student loans could be discharged after a relatively short number of years.  Applied in today’s setting of perpetual indebtedness, the rule was an anachronism.

Let’s hope his view catches on.

 

Image courtesy of besighyawn.

Student loans ensnare parents

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Should you guarantee a student loan, asks my good friend Doug Jacobs.  His is the cool, reasoned analysis.  I want to jump up and down and say DON”T DO IT.

It pains me to say that.  My undergraduate education was funded in part with modest student loans.  I believe education is the key to much that is personally  positive and societally important. I applaud the public policy that is willing to make college more widely affordable.

Student loans have taken on a malevolent quality over the past years.  Loans are made apparently without any counseling about the consequences of getting a four year degree at an expensive private school in art history.  (That was one of my early cases:  $100,000 in loans for a skill set that allowed my client to earn $21,000 a year).    Since student loans aren’t dischargeable, they have the potential to blight the life of a student who borrows too much, never uses the skills acquired, or who finds the economics of the profession changed between school and career.

The new private student loans bear interest rates akin to credit cards, according to a recent story in the New York Times.  The Times  blog  rounded up more on student loans.

Then there’s the issue of timing:  parents guaranteeing the loans of their children face having student loans hanging over them as they approach retirement.  The student defers payment on the loan, keeping the parents exposed to the debt.  It entwines the two generations financially long after the student is an adult.  Retirement budgets seldom have available dollars to pay off student loans.

My advice is to approach parental guarantees of student loans with the same caution you use when confronted with a coiled rattlesnake.

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