Getting your federal student loans forgiven seems like a dream come true. The federal government offers great repayment plans like IBR and PAYE. For many, it means making payments based upon your income for 20 to 25 years, and then the balance disappears. For public servants, it is 10 years of payments and then forgiveness. Regardless of your situation, paying back some of your debt is preferable to paying back all of your debt.
Unfortunately, there are some major limitations and risks associated with targeting student loan forgiveness.
Risk 1: The Interest
Depending upon your income, your monthly student loan payments can be very low, even $0 per month. One of the problems with being on an income based repayment plan is that your balance will continue to grow if your monthly payments are lower than the monthly interest.
Even if you pay enough each month to lower the principal balance, by not aggressively paying off your loan, you may end up spending more on interest.
An Example: Gus and Dave both have $30,000 in student loans at 6.8% interest.
Gus enrolls in the PAYE plan, and pays the minimum for 20 years, and gets the rest forgiven. Based upon Gus’s income, his monthly payment were $200. By making the minimum payment over 20 years, he had nearly $15,000 in student loans forgiven! Gus thinks he got a pretty good deal.
Alternatively, Dave paid off the loan under the standard 10 year repayment plan. His monthly payments were just a hair under $350 per month. After 10 years, his loans were paid off.
Based upon these numbers it would seem like Gus came out ahead. However, if you look at the interest spending, Gus actually paid a lot more than Dave. Over the life of his loan Gus actually spent about $48,000 getting rid of his $30,000 loan (In this scenario Gus would actually pay out over $32,000 in interest payments to get a portion of his $30,000 loan forgiven). On the other hand Dave, who paid off his loan in full, spent less than $42,000 total.
In the end Gus spent less each month, but Dave spent less overall.
Based on the example, one fact should be clear: just because you can get a portion of your loan forgiven, it doesn’t necessarily mean that you will come out ahead in the long run. What ends up being the best deal for you will depend upon your total loan balance, interest rates, and income.
Risk 2: Taxes
If you look at the fine print on the IBR and PAYE student loan forgiveness options, you will see that debt forgiven is actually considered taxable income (Note: if you get your loans forgiven under the Public Service Forgiveness Option, this particular tax concern does not apply).
Lets go back to our previous example. Gus, who paid more in interest, but got approximately $15,000 in student loans forgiven, will have to pay tax on that forgiven debt. The IRS treats forgiven debt the same as income. That means that on top of the regular taxes that Gus would normally pay, the IRS will tax him on an extra $15,000 of income!
If you do plan on getting student loans forgiven after the 20 years on PAYE, you should also make sure that you are saving up for a big tax bill that year. Otherwise your massive student loan problem will become a massive tax problem.
Risk 3: The Government
Student loan forgiveness was created by an act of Congress. Since 2007, when the bill was first passed, legislators have been able to brag about this perk to young voters. In 2017, the bill comes due. 2017 is the first year that people will actually qualify to have loans forgiven (this will be when the first public servants become eligible under the program). As the years pass more and more people will qualify for the program.
Without the benefit of a crystal ball, there is no way of knowing what Congress may do in the coming years to change the student loan laws. On one hand it is possible that they will change it so that people like Gus don’t have to pay taxes on their forgiven student loan debt. On the other hand, they could make things much more difficult for borrowers. Until your loans are paid off or forgiven, the risk of the government changing things will always be there.
Risk 4: Red Tape
Even if you do the math, think about all the different possible outcomes and pick the best plan, there is still the possibility that things might go wrong for you.
The nightmare scenario is making years of payments only to learn that your loan isn’t eligible or that you were on the wrong repayment plan.
In the Student Loan Sherpa Forums, one reader shared his horror story of learning that his lender was not counting 5 years of payments towards student loan forgiveness.
Research and diligence can help you prevent this from happening, but with student loans being a complicated and ever-changing subject, the risk of your efforts not counting is something to keep in mind.
Income based repayment plans and student loan forgiveness are amazing options that will help out many borrowers. However, just because they are good options for some, it doesn’t mean it is the best option in every situation. Student loan forgiveness does have its risks, and if you are not careful, you could end up spending more money in the long run.