By Dr. Jim Dahle, WCI Founder
Over the last 20 years—and especially in the last five years—the federal government has made changes to the federal student loan programs to help individuals and families with the cost of higher education. These changes often have undesirable effects and unintended consequences. One of the most significant of these consequences is “moral hazard,” an economic term for when people make different decisions than they otherwise would have as a result of policy.
Essentially, moral hazard is when someone no longer has an incentive to guard against risk because they are protected from the consequences of that risk. A classic example of moral hazard might be how you drive that rental car after you pay for full insurance coverage on it. You would never drive your own car that way, but hey, it’s a rental!
Education and Federal Student Loans
The cost of higher education has skyrocketed over the last couple of decades, going up in price often at twice the general rate of inflation. While many factors affect this phenomenon, one of the most significant is the ease with which students can borrow money to pay their tuition bills. Got a pulse and a medical school acceptance? Then, you can borrow hundreds of thousands of dollars. The school gets its money right away and does not have to care about whether the student gets the degree—much less whether they can get a job afterward that will allow them to pay off the debt they took on to get that degree.
The upside of a generous student loan policy is that students from poor families can become doctors. The downside is that those same students now owe $500,000 instead of $150,000 in student loans, and the rich student families had to spend half a million, too.
To prevent discrimination, the federal government has decreed that any student can borrow as much as they want, up to the cost of attendance less the expected family contribution (now known as the Student Aid Index). The federal government will even insulate the lender from the risk of making huge loans to terrible students pursuing useless degrees. All of this introduces massive amounts of moral hazard to the process.
The Moral Hazard of Income Driven Repayment and Forgiveness
Over the last two decades, federal income driven repayment (IDR) and forgiveness programs have become significantly more generous. This has introduced an even larger degree of moral hazard into decisions about how to pay for medical school and how to manage student loans. In a recent webinar The White Coat Investor did for students, the most common question involved whether somebody should use their own money to pay for medical school or borrow federal loans in hopes that the taxpayer would eventually pay for their education. Here is an example of a variation on the question:
“I am starting medical school this year, and tuition will be about $46,000 each year, adding up to about $184,000 over four years. My spouse makes a salary of $83,000 which will pay for our living expenses during school. We have $125,000 in savings in a Fidelity brokerage account. Would it be better to pay as much of my tuition as possible in the next four years to minimize the amount of debt I will graduate with, or would it be better to contribute the max amount to each of our Roth IRA accounts? I want to contribute to the Roth IRA accounts and pay some tuition, but I am wondering which is more important to prioritize.”
In essence, this prospective medical student is considering taking on student loans at 7%-8% so they can invest money. At first glance, that’s a terrible idea. Even at today’s higher interest rates, you can only make about 5% on cash, so avoiding taking on debt at 7%-8% is the equivalent of earning a risk-free 7%-8%. That’s a very attractive proposition, especially since many people don’t even expect risky investments like stocks to do much better than that in the long run. It’s one thing to borrow at 2% and earn 5% in a money market fund or hope to get 8%-10% in stocks. It’s completely different to borrow at 8%.
Why would a student even consider doing that? Two words. Moral hazard.
What if your effective interest rate really wasn’t 8% but something much lower thanks to the SAVE subsidy? What if there is a possibility that the government forgives your student loans, either with or without an associated tax bill? Now, it’s not such an easy decision, is it? Given the trends of the government becoming more and more lenient with its IDR and forgiveness programs, can you really fault a student who wants to bet on the government becoming even more generous in the future? I can’t.
It’s one thing to disagree with government policy. It’s entirely different to tell someone they should not take advantage of a completely legal method of obtaining a benefit worth hundreds of thousands of dollars. The federal IDR and forgiveness programs are a huge boon to the most educated and the most indebted among us. In essence, via their elected representatives, taxpayers have decided that they should transfer a large amount of wealth to doctors. Whether they are consciously doing this or have been hoodwinked, I really can’t say. But I don’t think it’s unfair to say that IDR and forgiveness programs benefit doctors more than anyone else. I almost don’t want to point this out, lest the taxpayers and their representatives realize what’s going on here, and it results in less generous benefits for current and future white coat investors.
More information here:
The Role of Student Loan Refinancing in 2024
How I Financed Medical School After a Late Start (and How SAVE Changed Everything)
How Much Are Doctors Actually Getting?
How generous can these benefits really be? Imagine a student who came out of medical school in 2014. The student makes trivial payments while in residency and fellowship from 2014-2020. Then, the student loan holiday hits, and no payments are due for 3 1/2 years while the doc works full-time for a nonprofit hospital. It takes the Department of Education a while to recertify the incomes, and by that point, 120 monthly “payments” have been made. It is entirely possible that these doctors paid less than $5,000 of a $400,000+ debt before the remainder was forgiven tax-free.
Consider another student who graduates with an undergraduate degree and $20,000 in student loans and works for a nonprofit for four years making IDR payments before going to medical school, where the student borrows another $400,000. All the loans are then consolidated, and the student finds out that they have already made 48 of the 120 monthly payments required for PSLF. The doctor then spends six years in residency and fellowship making trivial payments before $400,000+ is forgiven.
Meanwhile, the doctors and their families who scrimped and saved and “did the right thing” are standing there feeling like schmucks. It’s a little bit like doctors who refinanced their federal student loans to 3% in February 2020. For about four weeks, they felt really smart. Then they felt really dumb when President Trump announced that interest rates were going to be 0% and payments were going to be $0. They got to feel dumb again every time (on nine separate occasions) that the student loan holiday was extended over the next 3 1/2 years.
Even those of us trying to help doctors be smart with their money are left feeling like schmucks. We give thoroughly researched advice with the best knowledge we have at the time, and then a few months later, the game changes. I told plenty of people in 2020 that they might want to consider refinancing those student loans while rates were at historic lows, even if it meant they had to make a few payments and pay 2%-3% interest instead of 0% interest for a few months. But I had no idea the holiday was going to be extended nine times. I didn’t know that REPAYE was going to become even more generous when it became SAVE. I didn’t know that 1099 physicians contracting with nonprofit hospitals in Texas and California were going to become eligible for PSLF several years later. I didn’t know that FFEL loans would be allowed to be consolidated into direct loans.
Now, I’m hesitant to tell anybody anything, because the rules of the game are probably going to change again in a few months. We actually received a fair bit of criticism about this in our annual survey this year. I guess people expected me to have a less cloudy crystal ball. Funny, nobody ever comes by and says thanks for telling us about PSLF and pointing out it was actually going to work from 2011-2019 when everyone else was saying it wouldn’t. My crystal ball was pretty clear about that, but I sure didn’t see a 3 1/2-year student loan holiday coming, not to mention SAVE and the IDR waiver.
Between higher interest rates and the continuous stream of news articles about various types of student loan forgiveness, almost nobody is refinancing their federal student loans these days, and I suspect few borrowers are actually paying off their student loans any faster than they must. The Pavlovian announcements of more and more generous student loan policies have conditioned today’s borrowers to just hang on until the Department of Education cavalry eventually rescues them from their student loans.
Unforeseen Effects in the Job Market
Consider these rather serious comments made on a rather unserious post on April Fools’ Day this year:
“#1 PSLF really should be canceled for physicians and other high income earners, but kept for lower income jobs. There is no reason someone making $150,000-$600,000 should have their loans forgiven. Dentists have the same loan burden but almost no dentists get their loans forgiven. Similar for pharmacists. Complete b.s. law.”
Unforeseen consequence? More physicians and fewer dentists and pharmacists.
“We are a small practice trying to recruit for many years. There are many FQHC and RHC clinics around that can offer PSLF. The candidates we interview go to work at those clinics. You can’t compete with the half a million tax free money. We are looking at the end of small practices.”
Unforeseen consequence? Harder for private practice to compete with academia for new graduates.
The Rubber Hits the Road
Let’s get back to this incoming MS1. This couple already has $125,000. The spouse is making $83,000 per year. If the spouse’s income can cover their living expenses plus $15,000 per year in tuition (which seems very reasonable to me), this student should graduate from medical school debt-free. Alternatively, the student could potentially borrow $150,000 or even $200,000 (I’d have to fill out a FAFSA to determine the actual amount the student can borrow) over the course of four years. Or, as the student is considering, they could split the difference.
What should the student do? How would you advise them? Is there a moral obligation for this family to pay their own way even if there is no legal one? I don’t think there are any easy answers to this question.
More information here:
We Quit Paying Extra on Our Student Loans (and Why It Feels Dangerous)
Should You Pay Off Debt or Invest?
Pros of Paying for School with Your Own Money
There are still a fair number of reasons for this couple to just pay for school. Let’s go through them.
#1 Avoiding Debt
Most of us don’t feel very good about owing money to other people. Some feel a religious conviction to avoid it as much as possible. Others feel immoral borrowing money they don’t actually need when it could be used for a “better” cause. If you pay for school, you won’t have any student loans.
#2 No Student Loan Management Hassles
It’s beautiful to buy a car from a dealership and never walk into the finance office. It’s faster and involves less hassle, and nobody cares about your credit score. The same thing applies to paying cash for school. Some types of forgiveness require you to deal with paperwork, payments, and hassle for almost three decades. That’s over one-third of your lifetime.
#3 No Fees
The interest on student loans is bad enough, but there are also fees associated with them. These origination fees range from 1% to over 4%. Borrowers who will be paying back their loans eventually not only have to out-earn the interest rate, but they also have to out-earn the fees.
#4 Federal Student Loan Rates Are Fixed
Those borrowing from the government in 2023-2024 for medical school are paying interest rates of 7.05%-8.05%. If interest rates fall in a year or two, those loans they borrowed are STILL at 7%-8%. They don’t even have the option to refinance them until they graduate, and most doctors don’t refinance until a year or so out of training. Just because rates go down doesn’t mean your rate will go down. Imagine having 8% student loans when you can only make 1% on cash. That wouldn’t feel very good.
#5 Career Risk Is Real
Things happen, and careers don’t always go as planned. The quickest forgiveness program out there is PSLF, which generally requires 14+ years in the program from MS1 until forgiveness is received. Fourteen years is a long time for everything to go perfectly. Consider all of the following catastrophes that could ruin this sort of plan:
- The doctor doesn’t match into a residency.
- The doctor is disabled enough to not be able to practice medicine but not enough to have the student loans eliminated.
- The doctor no longer wants to practice medicine.
- The doctor no longer wants to work full-time.
- The doctor can’t find or doesn’t wish to take a PSLF-qualifying job.
The match rate has been dropping for years as medical school slots increase at a faster rate than residency slots. In the 2023 match, 99% of program slots were filled. But only 81% of those who submitted a rank list actually matched. That meant 19% of applicants, most of whom owe six figures in student loans, were told they could be doctors but they couldn’t practice medicine. Many of them will probably match the next year, but a significant number will never match. It’s not too hard to find a PSLF-qualifying position in medicine, but after failing to match, your career choices are limited to jobs that will qualify for PSLF. Yes, you could go for SAVE forgiveness in 25 years, but just saving up for the tax bomb will be no small feat without a doctor’s income.
If you just pay for school, you can do whatever you want for a career (or nothing at all).
#6 Legislative Risk Is Real
Congress can change the rules any time it wants. Barring the Supreme Court getting involved, the Department of Education can change the rules whenever it wants. But policy can swing both ways. Just because student loan policy has been getting more generous over the last couple of decades, there’s nothing to say it couldn’t become less generous over the next decade. Maybe PSLF and SAVE will become means-tested. Maybe they’ll go away completely. Maybe PSLF will be extended to 15 years of payments instead of 10, or payments won’t start counting until you finish training. Yes, the fact that PSLF is mentioned in your promissory note should provide some level of protection and you’ll probably be grandfathered in to the old rules, but there are no guarantees.
#7 Do You Really Want Your Financial Life to Revolve Around Your Student Loan Plan?
I’m now almost 18 years out of residency and 21 out of medical school. If I was going for SAVE forgiveness, I would still be four years away from it. Meanwhile, I’ve started a business, gone part-time, served in the military, become financially independent, paid for college educations, paid off a mortgage, and more. I can’t imagine that if every time I was faced with a career or investing decision for the last 21 years, I would have had to consider the implications of that decision on my student loan plan. How many times would I have chosen something different? Used a different retirement plan or type of contribution? Chosen a different investment? Filed my taxes differently? Taken a lower-paying job or worked less or not asked for a raise? If you don’t have student loans, you don’t need a student loan plan, much less one that lasts 14-29 years.
Pros of Borrowing Money You Don’t Need to Pay for Medical School
There are obviously some pros to borrowing money, even if you don’t need it. Let’s go through those, too, so today’s students can make an informed decision.
#1 Public Service Loan Forgiveness (PSLF)
The main reason to take out student loans you don’t need is simply because of the possibility that those loans will turn into a handout. Who wouldn’t want a free $200,000-$400,000? I certainly wouldn’t turn it down if a representative of the DOE showed up on my doorstep and handed me a $300,000 check. I’d cash it. As an MS1, you won’t know if you’re going to take a PSLF-qualifying job for 7-10 years. Won’t you feel dumb if you paid for school yourself and then ended up working at the VA for a few years after residency? Or even just for a physician group in California that contracts with a nonprofit hospital?
#2 SAVE Forgiveness
It isn’t just PSLF that has become more generous over the years. IDR programs have also become more generous. Under SAVE, unpaid loan interest is waived. That means there will be less interest accruing on your student loans as you work your way toward SAVE forgiveness after 25 years of payments. So, there will be less left to forgive, and the tax bomb will be lower. While SAVE forgiveness is not quite as attractive as PAYE forgiveness after 20 years (which will soon no longer be an option), it’s still much more attractive than REPAYE forgiveness ever was.
#3 Some New Forgiveness Program
Maybe there will be another forgiveness program. Maybe there will be a massive student loan debt jubilee, and all student loans will be waived by President AOC and her liberal Congress. Who knows? But if you don’t have student loans because you paid cash, you paid them off, you refinanced your loans, or you never went to school in the first place, then you won’t get to benefit from that jubilee. Maybe the next version of SAVE will be even better. You don’t want to miss out on that, do you?
#4 Another Student Loan Holiday
Likewise, maybe there’ll be another student loan holiday when we go to war with Iran or North Korea and there’s a recession. Maybe you’ll get 0% and $0 payments for five years that time instead of just 3 1/2. Who says pandemics are a once-in-a-lifetime event? Look, I’m just saying the quiet part out loud here. This thought is going through plenty of borrowers’ heads.
#5 Flexibility
Just because you borrow the money doesn’t mean you can’t change your mind. If you decide as an MS2 or a PGY2 that you no longer like this debt, you can take that $125,000 you have (probably more by then due to investment earnings) and pay it off. But if you never borrow it in the first place, you can’t come back later and borrow it.
#6 Time Value of Money
That $125,000 this couple has (along with perhaps another $15,000 added to it each year plus investment earnings) is not just going to sit there. It’s going to be invested. At 10%, money doubles in seven years and quadruples in 14. That could easily be half a million dollars by the time PSLF happens. Meanwhile, the SAVE subsidy might keep the loans from compounding at 8%, and student loan interest often isn’t capitalized immediately anyway. The longer this game is played, the more time value of money that cash that you would have used to pay for school is worth. Even if you go for SAVE forgiveness, you may end up with more money than you need to make all of your payments, pay the tax bomb, and have something left over.
More information here:
8 Controversial Student Loan Management Techniques
The Bottom Line
What a tough decision students today have—at least those for whom borrowing for medical school is optional. I’m sorry you’re facing this. I don’t know what I would do if I were in your situation. I’d probably be very tempted to take out loans I didn’t need. However, I do know what I would NOT do. I would not sign up to have the military pay for my schooling. It seems silly to spend four years on active duty getting deployed and making half as much as I could make at a 501(c)3 job when I’m not paying for medical school either way. No wonder the military is having so much trouble recruiting. Even if someone wanted to be a military doctor, why not just take out the student loans, avoid the military match, get a bigger signing bonus coming in, perhaps get some control over your first duty assignment, and still get your loans wiped out via PSLF (military service qualifies)?
Unintended consequences. Moral hazard. Hard decisions.
What do you think? What would you do if you were a student today and had the means to pay cash for school? How would you run the student loan program if you were a US dictator? Do you think the generosity of the student loan programs for doctors is intentional or just a very happy unintended consequence? Comment below!
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