Wednesday, October 28, 2015

The Introduction to Student Loan Forgiveness

This post is from the introduction of my report student loan forgiveness.   A full copy of the report can be found on Kindle.
There is a free promotion for the five days 10/29/15 to 11/02/15.

The Introduction to Student Loan Forgiveness

A constant flow of official reports and news articles document the growing student debt problem. Standard & Poors found that student debt grew 10% per year since 2003 reaching $904 billion at the end of the first quarter of 2012.  Student debt outstanding is now higher than credit card debt or automobile loans outstanding.  A recent New York Times article highlighting the growing use of debt collectors to recover funds from defaulted student loans found that one in six borrowers were in default, the total dollar volume of defaulted loans was $76 billion, and that the Education Department paid $1.4 billion last year to collection agencies and other groups to collect defaulted student loans.  A Wall Street Journal article analyzing government data compiled by the Treasury Department found that from January through August of 2012 115,000 people had funds from their Social Security check garnished to pay off student loans compared to 60,000 cases in 2007 and only 6 such cases in 2000.

The current generation of students is leaving school more highly leveraged than any previous one.  While education remains a good investment for the average student borrower, some students will never be able to repay their student loans in full.  Moreover, current bankruptcy law and procedures make it very difficult for borrowers with student debt to ever obtain a fresh start.  There is some interest in policies that might alleviate student loan debt burdens.  However, this interest is tempered by the concern that the provision of debt relief to student borrowers would impose large costs on taxpayers.  

This paper considers the possibility of changing policies and laws in order to make it easier for some highly leveraged students who are experiencing substantial economic hardship to have some or all of their student loans forgiven.  Three programs or policies – (1) the Income Based Replacement (IBR) loan program (2) the discharge of student debt in bankruptcy, and (3) the treatment of student debt in chapter 13 – are assessed.

My assessment of the IBR program reached the following conclusions:

·      The primary purpose of the program is to prevent students from defaulting on their student loans by reducing loan payments in years that the student debt is high relative to disposable income.  Under current rules, relatively few borrowers with chronically high levels of student debt relative to income will qualify for debt relief after 25 years.

·      Some analysts are concerned the IBR program will motivate some students to borrow more.  However, the amount of debt that is forgiven under IBR depends upon the lifetime income of the student borrower’s household, which is difficult to predict when a person is in school.  A modified less generous IBR program that offered a lower level of debt relief rather than complete loan forgiveness would not create a large incentive for increased borrowing.  

·      The take-up rate for the IBR program will be smaller than anticipated.  First, not all loans are eligible for the IBR program and borrowers who do not know the rules when taking out or consolidating loans will lose access to IBR benefits.  Second, some borrowers will choose a 20-year consolidated loan over a 10-year loan that is eligible for reduced IBR payments.  Third, most married borrowers will not choose to maximize IBR benefits by filling separate tax returns because this would increase their tax liability.
·      Individuals with high levels of both student debt and other loans (non-secured consumer loans and mortgage debt) will often gain very little debt relief under IBR despite their high leverage. 
My assessment of the impact of the bankruptcy code on student debtors reached the following conclusions:

My assessment of rules governing the discharge of student debt in bankruptcy:

·      The rules governing the discharge of student loans in bankruptcy are highly subjective.  While outcome differ across courts, in most cases even student debtors in extremely dire economic circumstances have a difficult time getting student loans discharged in bankruptcy.  Since 2005, the stringent rules governing the discharge of student loans pertain to private student loans as well as government-backed loans.

·      The rules governing the discharge of student loans in bankruptcy could be modified to provide limited debt relief to borrowers in extreme financial circumstances without imposing substantial costs on taxpayers.

My assessment of rules governing student debt in chapter 13:

·      The 2005 bankruptcy law forced many student debtors to file chapter 13 rather than chapter 7.   Many student payments can only make minimal payments on their student loans while in a chapter 13 payment plans.    The combination of low payments on student loans and the fact that student loans are not discharged prevents student debtors from obtaining a fresh financial start in bankruptcy.

·      The repeal of the chapter 13 means test would facilitate quicker repayment of student loans and benefit both student debtors and taxpayers.   A rule that provides priority to student debt payments over other unsecured debt payments in chapter 13 bankruptcy will improve the status of student debtors and taxpayers and still leave creditors better off than they were prior to the 2005 bankruptcy law.

·      Modifications to current bankruptcy law designed to help student borrowers will likely accrue to a less affluent group of borrowers than changes to IBR. 
       Concluding Remarks:

The goal of debt forgiveness policies both inside and outside of bankruptcy is to balance two competing objectives – the provision of a fresh start to debtors and fairness to creditors.  The 2005 bankruptcy law resulted in bankruptcy becoming much more supportive of the rights of creditors and less concerned about providing a new opportunity to debtors.  It is now especially difficult for individuals who borrow funds to further their education to obtain debt relief. Several policy changes, including both modifications to IBR and changes to the bankruptcy code, might provide modest debt relief to student borrowers, maintain strong incentives against default, and protect taxpayer interests. 

The full report on student loan forgiveness can be found on Kindle.  It is free for the five day period starting 10/29/15.

Student Loan Forgiveness:

Also, people might be interest in my new book on Kindle

Nine Essays on Debt and Your Retirement.

Sunday, October 11, 2015

Essay Nine: Pay off the mortgage or add to the 401(k)

The nine essays on debt and retirement are available on Kindle, Ibooks, and Nook.   Essay nine printed below examines the issue of whether a person nearing retirement should pay off the mortgage or contribute more to her 401(k) plan.   My advice in this and most instances favors debt reduction over asset accumulation.

A previous post described the nine essays

Essay Nine: Mortgage Debt and 401(k)
Assets in Retirement

Increasingly, many Americans nearing the end of their work life find they have a large mortgage and must choose between paying off the mortgage or contributing more funds to their 401(k) plan.  A large number of financial advisors advise their clients to increase 401(k) contributions rather than pay off their mortgage.

My view is that it is essential for people nearing retirement to eliminate their mortgage debt even if this goal requires some reduction in 401(k) contributions.   I have two reasons for this view.   First, as noted and explained in the previous section 401(k) plans are not capable of mitigating the impact of market down turns at the end of a career or during retirement.   Intuitively, a person with no debt is much better able to withstand market downturns than a person with a mortgage.   The Wall Street analysts always say don’t sell on a panic the market will come back.   Well retirees with a large mortgage often have no choice but to sell.

Second, the financial risk considerations interact with another factor, the tax treatment of 401(k) plans.  During working years mortgage interest and 401(k) contributions reduce income tax burdens.   During retirement a person with a large mortgage payment and most financial assets inside a 401(k) plan will pay more in tax than a person without a mortgage.

All disbursements from a 401(k) plan are fully taxed at the ordinary income tax rate.   A person with no mortgage disburses enough to cover discretionary expenses and taxes   A person with a mortgage must disburse enough to cover discretionary expenses, the mortgage and taxes.

The disbursement to cover the mortgage leads to additional taxes because all disbursement from the 401(k) plan is taxed.  MOREOVER, THE DISBURSEMENT ON FUNDS USED TO COVER THE TAX ON THE 401(K) DISBURSEMENT IS ALSO TAXED.

Part of Social Security is taxed for people with income over a certain threshold.  A quick way to find out if part of Social Security benefit is taxable is to compare your income to the threshold for your filing status -- $25,000 for filing status single and $32,000 for filing status married.

Higher disbursements from the 401(k) plan can increase your adjusted gross income beyond the threshold and increase the amount of the Social Security benefit subject to tax.   Of course any 401(k) disbursement used to pay the income tax is also taxed.

So let’s take a household with all financial assets in their 401(k) plan with a $30,000 annual mortgage.   This monthly mortgage is $2,500, not huge.   Let’s assume that the person has to pay around $1,000 more in tax on Social Security benefits because of the additional disbursement to pay down the mortgage.  A first order approximation of the amount of additional tax needed because of the additional $31,000 disbursement is $31,000 x the marginal tax rate for the taxpayer.   For most filers the marginal tax rate would be around 25 percent in 2014.  

So the taxpayer with the mortgage and the additional tax burden because of the additional 401(k) disbursement will probably disburse $39,000 more per year from their 401(k) plan.

This analysis puts a whole new wrinkle on the question how much money does one have to save in their 401(k) to have a secure retirement.   The answer is much more if you have not paid off your mortgage.

Note that the disbursement to cover the unpaid mortgage must occur whether the market falls or rises. 

Many people who choose to add to their 401(k) plan rather than pay off their mortgage prior to retirement are going to have sell their home and downsize.  Downsizing may make sense but most people don’t want to downsize until they are fairly old.

Some people who end up selling their home may choose to rent rather than buy a new home.   The main risk of choosing to rent throughout retirement is that home prices and rents may rise.    This exacerbates longevity risk.

Downsizing should be a choice not an outcome from a failed financial plan or worse the result of financial advisors putting their interests over your interests

Concluding thoughts on mortgage debt in retirement:  An increasing number of households are retiring prior to their mortgage being entirely paid off.  Surprisingly, the existence of a mortgage in retirement is often consistent with a financial plan developed by a financial planner.   Many financial analysts and planners advise their clients to increase savings in their 401(k) plan rather than retire their mortgage.

These financial planners are not being upfront with their clients.   Retirees with mortgage debt and all or most financial assets in a 401(k) plan are at the whim of the market and have a substantial tax obligation.   The advice that put people in this position is in my view a form of malpractice.

Appendix to Essay on Mortgage Debt and 401(k) Assets in Retirement

The issue of whether to pay off a mortgage or contribute to a 401(k) plan for an older worker is related to the issue of mortgage choice, especially for older homebuyers.   The following question addresses the interaction between mortgage choice and 401(k) investment strategy for an older worker.

Question:   A 50 year-old person is buying a house and must choose between a 15-year mortgage and a 30-year mortgage.   The mortgage choice will impact how much money the person can contribute to his or her 401(k) plan.  

The person makes $80,000 per year.  The initial mortgage balance is $400,000.   The person’s 401(k) balance at age 50 is $200,000.  The 30-year FRM rate is 3.9 percent and the 15-year FRM rate is 3.1 percent.  

Discuss the advantages and disadvantages of two strategies (1) taking the 30-year FRM and investing 15% of salary in the 401(k) plan and (2) taking the 15-year FRM and investing 5% of salary in the 401(k) plan.


Let’s start with a reiteration of mortgage choice issues a subject previously broached in essay four. 

Observations and Thoughts on Mortgage Choice Issues:

·      The monthly payment on the 30-year FRM is nearly $900 less than the monthly payment on the 15-year FRM.  The higher mortgage payment on the 15-year FRM will all else equal require the person who chooses the 15-year FRM to make a smaller 401(k) contribution than the person who chooses the 30-year FRM.

·      After 15 years the 15-year FRM is completely paid off.   The remaining loan balance on the 15-year FRM is around $257,000.

·      Note that gains from the quicker pay down on the 15-year mortgage are not dependent on market fluctuations.    The gain from debt reduction occurs regardless of whether the market is up or down and regardless of when bear or bull makers occur.

Analysis of 15-Year Versus 30-Year FRM

Loan Balance
Future Value

Observations and Thoughts on Two 401(k) Contribution Strategies:

As noted in essay eight, the final 401(k) balance after 15 years depends on both the rate of return of the market and the sequence of the returns in the market.   Outcomes are presented for two market scenarios.   The first involves 7% returns for the entire 15-year period.   The second involves 7% returns for 10 years followed by -4% returns for 5 years.

·      The difference in the final 401(k) balances (high contribution minus low contribution) under the 15-year bull market scenario is around $211,000.

·      The difference in the final 401(k) balance (high contribution minus low contribution) under the 10-year bull and 5-year bear scenario is around $131,000.

Analysis of Different 401(K) Contribution Strategies
5% Contribution Rate
15% Contribution Rate
7.0% Return for 15 Years
7.0% Return for 10 years followed by -4.0% return for 5 years

The initial balance in the 401(k) plan for both scenarios is $200,000.

Additional insights on the tradeoff between 401(k) contributions and mortgage retirement:

·      The 30-year mortgage/high 401(k) contribution strategy results in major tax savings during working years compare to the 15-year mortgage/low 401(k) strategy.   All mortgage interest is tax deductible and the 401(k) contribution is not taxed.

·      The 15-year mortgage/low 401(k) contribution strategy results in major tax savings during retirement compared to the 30-year mortgage/high 401(k) strategy.   The previous example in this section demonstrated exposures for the person with mortgage debt in retirement when the person is dependent on 401(k) disbursements.   Remember all disbursements from a conventional 401(k) plan including disbursement used to pay the mortgage and disbursements used to pay taxes are fully taxed at ordinary income rates.   By contrast, the money gained from paying off the mortgage and most capital gains on owner-occupied real estate is not taxed.

·      Financial risks associated with a bull market persist through retirement as long as the saver allocates 401(k) assets into equity. 

Tuesday, October 6, 2015

Nine Essays on Debt and Your Retirement

The book "The Nine Essays on Debt and Your Retirement," is now available on Kindle, Ibooks and Nook.  

Essays on Debt and Your Retirement

David Bernstein


Most financial advisors, bankers and realtors that you will interact with during your life time stress the importance of asset purchases and are generally oblivious to issues pertaining to controlling the amount you borrow and will ultimately repay to your creditors. Financial firms want you to contribute to your 401(k) plan as soon as you get out of school, even if you have extensive credit card or student debt and lack a basic fund for emergencies.   Realtors and bankers want you to buy a house with a 30-year mortgage, (assuming you qualify for the mortgage) even if you have credit card debt and student loans and even if it is highly likely that you will have to relocate within a decade.

Realtors and bankers will never advise you to delay purchasing a home until the student loan is paid down or to delay a home purchase until you can qualify with a 15-year rather than a 30-year mortgage.  Realtors and bankers will never tell you to stay in your current home for a few more years in order to build up equity for the second home.  

Financial advisors and brokers will seldom if ever recommend that you reduce your contributions to a 401(k) plan in order to more quickly pay off credit card debt, obtain a 15-year mortgage instead of a 30-year mortgage, more quickly eliminate student loans or use funds to reduce debt and improve your credit score. Realtors, bankers, financial advisors and brokers are united in their view that the best ways to reduce taxes is to leverage yourself up with a big mortgage and plow a lot of money into your 401(k) plan and if you have extra left over buy stocks.  However, delaying loan repayments in order to fund a 401(k) can lead to higher interest rates and hundreds of thousands in additional debt payments over the course of a lifetime.

In past generations, it has not been unusual for a person or a household to buy 3 or more houses during their lifetime.   Typically, each house was purchased with a 30-year mortgage.   Often the house would be sold or the mortgage refinanced in 5 to10 years.     As a result, many workers nearing retirement have a substantial mortgage.  Interestingly, many financial advisors advocate 401(k) accumulation over mortgage reduction for older workers.   

A financial formula that leads to match of a risky 401(k) asset filled with equities and a mortgage debt at retirement is not a viable strategy.   The value of the 401(k) plan fluctuates with the market.   The retiree with a mortgage and a 401(k) plan must make additional disbursements to cover both the mortgage and the tax on the additional disbursement.   Most individuals with substantial mortgage debt in retirement will have to sell their home and downsize if most of their financial assets are in 401(k) plans, even if returns on assets in the 401(k) plan are reasonably high. 

Estimates of the proportion of workers who will likely have inadequate retirement income will range from 50 percent to 70 percent.  Some articles on the adequacy of retirement income: 

The financial plan used by the baby boom generation has failed.  Moreover, financial challenges are even more daunting for the new generation of workers.

·      First, the current generation starts their career with substantially more debt than previous generations.   The average student loan for all age groups has gone from around $15,000 in 2005 to around $29,000 in 2015.

·      Second, the current generation is having a slow start to their career.   Labor force participation has been down and unemployment up for the younger cohort of workers, especially during and after the last recession.  It is possible that older workers remaining in the workforce have displaced younger workers.   Also, it appears likely that the new cohort of workers are more likely to switch jobs more frequently during their career.

·      Third, the current generation lacks secure defined benefit plans and is even more heavily dependent on 401(k) plans and IRAs, which fluctuate in value with the market.  The percent of workers who have a defined benefit plan that provides annuity income at retirement has fallen from around 38 percent in 1980 to around 20 percent in 2008.

The view espoused and outlined in the essays published here is that debt management will have a more important impact on your financial security and your retirement than asset acquisition.   The advice obtained from the interdependent essays in this book differs from the advice that you will get from your realtor, broker or mortgage lender.  

The first essay describes and critiques a rent versus buy calculator displayed at the web site    The calculator uses input on house and renting costs and taxes to calculate the number of years it would take for a house purchase to be less expensive than renting.   The model is useful but has several limitations.  First, the model assumes constant house appreciation and does not measure the risk or variability associated with this forecast.  Second, the user of the model needs to consider the likelihood that he or she will have to move prior to recouping their investment.  Third, the model does not allow the user to consider advantages associated with delaying a house purchase in order to repay student loans and credit card debt.   

The second and third essays examine the impact of student debt and credit card debt on the ability of a person to qualify for a mortgage and estimated costs incurred when borrowers restructure student debt in order to qualify for a mortgage.  The example in the second essay involves a person with a very large student loan.  The example in the third essay involves a person with a substantial student loan and additional credit card debt.  The essays consider the costs and benefits associated with increasing the maturity of the student loan from 10 years to 20 years in order to purchase a home.   We also consider the potential advantages of more rapid debt reduction even if this goal requires a delay in the home purchase or a reduction in 401(k) contributions. 

An appendix to the second essay provides a description and assessment of the Income Based Replacement (IBR).   The IBR program allows eligible borrowers to link student loan payments to household income and provides for the eventual forgiveness of student loans.

The fourth essay provides background information on the choice between the 15-year FRM and a 30-year FRM.   There are advantages and disadvantages associated with both 15-year and 30-year mortgages.   The 30-year mortgage has a lower payment, which allows the borrower to take out a larger mortgage or make additional payment to her 401(k) plan.   The tax deductibility of mortgage income combined with the fact that interest on 30-year mortgages early in the life of the mortgage makes up the lion share of mortgage payments further reduces the cost of 30-year FRM mortgage payments relative to the cost of 15-year FRM payments.

However, housing equity growth is excruciatingly slow for 30-year mortgage.  There are several risks and costs associated with the slower growth rate for house equity.   First, the borrower with a 15-year mortgage will have less equity and may not be able to refinance their mortgage should interest rates fall.   Second, the increase likelihood of negative equity may make it difficult to sell the home.   (The homeowner with negative equity would have to pay the difference between the mortgage and the house price at the time the house is sold.)    Most importantly, the lack of housing equity becomes a major problem in retirement especially for retirees who use fully taxed 401(k) disbursements to fund consumption and mortgage payments.

The fifth essay examines how mortgage choice and housing or mortgage holding period impact lifetime house equity growth when people buy multiple houses in their lifetime and the down payment for the second home come from proceeds obtained from the sale of the first home.   The results presented in this essay indicate that people who use 15-year mortgages and who have a long holding period for their home and mortgage will retire with substantial house equity and with no mortgage obligation.  By contrast, people who use 30-year FRMs and have short holding periods will retire with little housing equity and substantial mortgage debt.

The sixth essay considers issues related to the use of adjustable rate mortgages (ARMs).   The lower interest rate on ARMS can reduce initial payments.  However, in virtually all instances payments will increase substantially once interest rates reset even if the general interest rate environment remains stable.   The numbers presented in this essay strongly indicate that consumers should shun ARMs with interest rate reset periods less than 5 years.

Essay seven examines issues pertaining to subprime mortgages, especially mortgages with penalties against prepayment.   The essay critiques the claim that prepayment penalties can be good for risky borrowers.  My analysis suggests that risks associated with subprime mortgages far exceed the lower possible interest rate.   The endorsement of these products by prominent academic economists strikes me as evidence of a perspectival bias in favor of the needs of the financial services industry and against the interests of the consumer.

Essay eight examines the role played by 401(k) plans and Individual Retirement Accounts.   Most financial advisors emphasize a key to a secure retirement is the early and continued investment of equity inside 401(k) plans.  However, many economists and financial analysts now recognize that the adoption of 401(k) plans has increased the number of workers who will have inadequate resources in retirement.   There is wide disagreement over whether the failure of 401(k) plans stems from inadequate participations and bad decisions by workers or the shortcomings of plans.

In my view, these explanations are not mutually exclusive.  My analysis found that even households who aggressively contribute to 401(k) plans and make astute investments often come up short if there is a market downturn near the end of a career.  Moreover, it is often the case that highly leveraged household will be better off paying off debt than contributing funds to a 401(k) plan.

Essay nine was prompted by the view held by several financial advisors that people nearing the end of their career should emphasize accumulation of assets in their 401(k) plan even if this approach requires them to hold a mortgage during retirement.  The analysis presented here documents two important reasons why the elimination of a mortgage prior to retirement should be the top objective.   First, people in retirement with mortgage debt who are reliant on 401(k) disbursement for cash will pay much more in taxes during retirement than retirees who have paid off their mortgage.   Second, the household who keep debt and builds up their 401(k) balance is exposed to substantially more financial risk than households who pay off their mortgage.  The discussion of the tradeoff between paying off the mortgage and building up 401(k) assets for workers nearing retirement is intertwined with the issue of choosing between a 15-year and 30-year FRM, the issue discussed in essay five. 

The paper concludes with a brief summary of my concerns discussed in the essays.  My worldview is pessimistic.   I am concerned that self-interested financial professionals are giving their clients inappropriate advice.  Moreover, tax incentives too often encourage asset accumulation over debt reduction.   People who fail to aggressively pay off their loans and remain in the market may eventually find the same fate as the player in the gambler’s ruin game.

Concluding Thoughts:

The interdependent essays in this book attempt to motivate an alternative path towards financial security for the current generation of workers.   The advice presented here differs sharply from the advice that you will receive from your realtor and your financial advisors or lenders.

The realtor’s job is to persuade you to buy or sell your home.   My advise for the person starting her career is to rent rather than buy a home if you have substantial student or consumer debt or will likely have to sell a house in order to relocate for career reasons.  Do not extend the term of your student loan to 20 years in order to purchase a house.  Do not take out an ARM that resets in less than 5 years or a subprime mortgage in order to obtain a lower interest rates.   The risk of these products is too great.  Remember that mortgage debt is detrimental in retirement so in order to pay off your mortgage you will have to stay in your home, use a 15-year mortgage and refrain from borrowing with second mortgages or home equity lines.

Your financial advisor’s job is to persuade you to invest in a 401(k) plan under all circumstances.   401(k) plans have many good features and should be part of your retirement plan.   However, your earnings are fungible and limited.    People starting their careers with large amounts of student debt or consumer loans and a shaky credit rating must consider the tradeoff between debt reduction and 401(k) contributions.  Your financial advisor will tell you that you should never refuse the employer match to a 401(k) plan or take out a 401(k) loan.  It is not difficult to come up with examples where this is bad advice. 

Your financial advisor and your mortgage lender are both likely to argue that adding money to your 401(k) near the end of your career is more important than paying off your mortgage.  The analysis presented here indicates this strategy will make you worse off than one emphasizing the elimination of all mortgage debt prior to retirement.

The traditional approach to financial planning – buy houses with 30-year mortgages and throw money into the market through 401(k) plans does not work.  Instead the new generation of savers needs to focus on debt reduction and growth in housing equity even if this approach delays the purchase of your dream house and decreases investments in 401(k) plans.

this is the kindle link to the Nine Essays.   Book is also available on Nook and Ibooks.