Getting federal student loans forgiven seems like a dream come true. In as little as 10 years, federal debt is eliminated and a huge financial burden is lifted.
The reality is that securing loan forgiveness can be a long a difficult process. While this form of debt elimination can certainly be achieved, it isn’t simple, and it comes with some serious risks.
The two main forms of student loan forgiveness are public service loan forgiveness, which can eliminate the debt after 10 years worth of eligible payments, and income-driven repayment forgiveness, which takes 20 to 25 years.
For many borrowers, loan forgiveness is the faint light of hope at the end of a long tunnel. For others, it is a strategy to eliminate a large amount of debt while spending as little as possible. No matter the perspective, it is critical to understand and avoid the risks associated with going after 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 total spending including interest, Gus actually paid a lot more than Dave. Over the life of his loan Gus spent about $48,000 getting rid of his $30,000 loan (In this scenario Gus would 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 income driven student loan forgiveness options, you will see that debt forgiven is actually considered taxable income by the IRS. (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. Many representatives consider it to be a government handout and a program that mainly helps affluent individuals who don’t really need the help.
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.
That being said, borrowers do have a couple protections. First, eliminating the program would be extremely unpopular with a large portion of voters, including teachers, nurses, and law enforcement. Second, the terms of Public Service Loan forgiveness are written into the Master Promissory Note that borrowers are required to sign. This contract between the government and the borrower is an excellent protection for borrowers counting on PSLF. The proposals to eliminate PSLF almost always grandfather in exciting borrowers.
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.
Though Public Service Loan Forgiveness became law in 2007, the 10-year rule means that only recently have borrowers been able to apply to have their loans forgiven. The results so far have not been pretty.
Of the first group of applicants 99% were rejected. There is certainly reason to hope that the numbers will improve, but given the high rejection rate it should be clear that forgiveness is far from a sure thing.
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.