Parent Plus Loans and Moral Hazard | White Coat Investor

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I hate Parent Plus loans.  And I hate how our higher education system and student loan system causes people to ask very good questions like this one:

Q. My parents graciously took out parent plus loans for my undergraduate education, in my mom’s name. I currently have about $150k in parent plus loans. My parents are currently paying by “income contingent repayment,” making payments of about $300 a month, covering nowhere near the interest. With my mom retiring in the next couple of years her income will decrease and the payments should decrease as well. Is there any reason to pay off these loans quickly? The loans are discharged with death (parents will be over 90 years old after 25 years of payment) and the forgiven amount is not taxed and not taken out of my mom’s estate. This seems almost too good to be true, do you have any experience with this?

Talk about moral hazard and malincentives. Here is the definition of moral hazard:

Lack of incentive to guard against risk where one is protected from its consequences, e.g. by insurance.

The moral hazard is that when people are not responsible to pay loans back (or pay a fair interest rate) they are likely to borrow more. While we are not always the classic homo economicus, we do respond to incentives. Incentivize people to do the wrong thing and many of them will do it. See this Twitter survey I did recently for details:

 

But back to the subject at hand, Parent Plus Loans.

 

How Parent Plus Loans Work

A Parent Plus loan is a loan taken out by a parent (grandparents cannot do it, even if they are the legal guardian, unless they formally adopt the kid) for their child’s education. It is a federal loan, but not a direct loan. Thus, it is not eligible for any of the good federal programs such as:

• Income Based Repayment (IBR)
• Pay As You Earn (PAYE)
• Revised Pay As You Earn (RePAYE)
• Public Service Loan Forgiveness (PSLF)

If the borrower or the student dies before the loan is paid off, the remainder is forgiven tax-free. If the borrower (but not the student) becomes permanently disabled, the remainder is forgiven tax-free. A parent plus loan (even just one) can be consolidated into a Federal Direct Consolidation Loan (interest rate rounded up to nearest 1/8th %) that is eligible for Income Contingent Repayment (ICR). ICR requires payments that are 20% of discretionary income and any amount remaining unpaid after 25 years is forgiven. That forgiveness is taxable at ordinary income tax rates in the year it is received.

Other terms on a Parent Plus loan are also worse, including fees and interest rates. For example, as of Feb 29, 2020, the rate on a typical direct student loan for a med student is 6.08%. On a Parent Plus loan it is 7.08%. It also has an origination fee of 4.236% (1.069% for a direct loan).

Parents sometimes also take out private student loans with their own terms, or even borrow against their house, 401(k), whole life insurance policy, or other assets.

 

Why I Hate Parent Plus Loans

I don’t really like Parent Plus Loans. I don’t even like the idea of a parent loan at all. I think if anyone is going to borrow for a student’s education, it should be the student. When you borrow for something, by definition it means you cannot afford it. If you could, you’d just buy it, at least if it costs 4% upfront plus 7% a year to get the money. I’m all for saving for your child’s education. I think it’s great that you want to help your child. But you should help them from a position of strength. A parent that borrows for their child’s schooling almost surely does not have their retirement on track. You’re not doing your child a favor by paying for their education and then having them worry about you for the last 30 years of your life.

This is particularly bad in a case where the child is going to become a doctor or other high income professional. Now you have parents who perhaps made $80K a year and are rapidly approaching retirement borrowing to pay for someone whose income will be $275K on average. How many retirements have been ruined by parent plus student loans? Here’s kind of the classic scenario:

Help!!! My Parent PLUS loans are presently in a forbearance that will end in a few months. My expected installment payments are more than my monthly income. I am retired and my husband is on disability retirement. We have another son presently attending college. What options are available to me (if any)? Do I ask for an extended repayment, or continue with an economic hardship deferment? My husband was a teacher for 33 years and I was a school nurse for 27 years; are there any programs to reward our years of service in an inner city environment? I am sure that I am not the only retired parent attempting to repay the Parent PLUS loans.

You like lists? I like lists. Here’s a list of all the reasons not to take out a Parent Plus loan to pay for your kid’s medical school.

1. The kid may become disabled and you’ll be stuck with the bill.
2. The kid may not match and you’ll be stuck with the bill.
3. The kid may not help you pay it back and you’ll be stuck with the bill.
4. You may end up making payments for 25 years only to get an unaffordable tax bill from one of my least favorite creditors.
5. The loans won’t be eligible for a REPAYE subsidy.
6. The loans won’t be eligible for PSLF forgiveness.
7. The loans won’t be eligible for the lower payments available in IBR, PAYE, and REPAYE.
8. The forgiveness takes 5 years longer than in PAYE.
9. The child may have some difficulty refinancing the loans into his name (although several of my recommended refinancing companies do this).
10. The origination fee is 4 times as high.
11. The interest rate is 1% higher.
12. It will keep you from reaching your retirement goals.

Okay, that’s probably enough. You get the picture. These loans suck and should be a last resort kind of scenario. I’d much rather see the student take out private loans and refinance them the first day of residency than have their parents take out a Parent Plus loan they’ll still have 25 years later.

 

Working the System

Now, with all that background information, let’s see if there is a scenario where a few people might be able to take advantage of a loophole. Imagine you have a parent with a very low income who is already quite elderly. Let’s say they were 40 when you were born and you’re a non-traditional student who started medical school at 35. Let’s assume they are living just on Social Security. That won’t stop the federal government from loaning to a parent. They don’t care about your debt to income ratio or your credit score. Heck, the student doesn’t even need to demonstrate “financial need.” All they care about is your “adverse credit history”:

• A current delinquency of 90 or more days on more than $2,085 in total debt; or
• More than $2,085 in total debt in collections or charged off in the past two years (before the date of the credit report); or
• Default, bankruptcy discharge, foreclosure, repossession, tax lien, wage garnishment, or write-off of federal student loan debt in the past five years (before the date of the credit report)

None of that? You’re good to go. Even if you’re 75 years old and living on Social Security.

So how much can you borrow? Well, it turns out the annual loan limit on a Parent PLUS Loan is the full annual cost of attendance minus other financial aid received by the student. There is no aggregate (cumulative) loan limit. So for most people, the Parent Plus loan comes on top of a maxed-out ($20,500/year) Direct Student Loan each year. Let’s say the cost of attendance is $100K and you get a direct loan for $20K. That leaves $80K a year in Parent Plus loan, so you borrow $360K there and the interest clock starts ticking.

Your kids finishes medical school (you’re now 79), your kid does a 3 year IM residency and a 3 year GI fellowship (you’re now 85), and you keel over at 86. The loan is forgiven tax-free. And that whole time you had the loans in hardship deferrals or at worst, consolidated them into an ICR eligible loan with $0 payments.

I’m not sure anyone intended that loophole to be there, but it certainly is there.

But how many people really fit into that loophole? Well, most kids are not born to 40-year-olds. They’re born to 20-35-year-olds. And most medical students don’t enroll at 35, they enroll at 24 or so. So the parent is much more likely to be 50 than 75. At 50, you’re likely to make 25 years of payments before dying. Remember the loans (once consolidated into an ICR eligible loan) are wiped out after 25 years of payments, but that comes with a big tax bomb. How big? Well, let $360K ride for 25 years at 7% and it’ll be close to $2M. The tax bill on that may be $600K or more, all due in a single year. Meanwhile, most parents of doctors are not impoverished, so the payments on that massive student loan may be quite substantial, even in an ICR program.

 

Ethical Ramifications

I really don’t like student loan plans that require anyone to be in debt for 25 years. There is a lot that can change with loan programs and with people’s lives that can screw up such a long-term plan. But there’s an additional ethical dilemma here–is it really right to borrow money which you have no intention of ever paying back, even if it is legal to do so? And don’t tell me it’s just like PSLF. With PSLF there is a requirement to serve the public in a specific way. So the taxpayer is usually getting something for their money. It feels to me like this sort of scenario (like IDR forgiveness) is taking advantage of the taxpayer’s mercy for people in a desperate situation, even though they are not really in one (at least not one that isn’t self-imposed.)

There are additional concerns, especially if the parent is making the payments. In essence, the doctor, likely the wealthiest of her siblings, is now receiving an additional inheritance, or at least an early inheritance. How will your siblings feel about that?

The bottom line is that yes, this plan works, but I think going down this route deliberately is unethical. If you choose to go down it anyway, at least have the courtesy to gift your parent enough each year to cover the payments and make it right for your siblings.

What do you think? Are you using this plan? What did your parents do with the Parent Plus loans they took out for you? Do you think this is unethical? Do you think it will work? Comment below!

Student Loan Refinancing Disclosures