Should I pay off student loans or wait for forgiveness

Michael Lux Blog, Mailbag, Student Loans 3 Comments

Anybody who has federal loans has to answer this one critical question.  Should I try and pay of my student loans, or should I try for student loan forgiveness.  Answering this question early on in your repayment process is critical.  If you want to go after forgiveness, you will want to pay the minimum towards your federal loans.  If paying off your debt is the approach, you will want to pay as much as possible as soon as possible.

This week a recent law school grad posed the following question:

I came across your site after I was hit with a ton of bricks that I may not be able to pay off my student loans. I am a new attorney, and like you, owe a medium-sized fortune in student loans, which is growing each year. I’ve been on IBR since graduation from law school in 2012. My rude awakening happened when I totaled up my student loans in May 2014 ($168K) and just looked at the balance now ($173K). I’m actually losing ground! At this rate, I’ll never pay be able to pay them off.

I was looking at the PAYE plan, but noticed that you can’t get that plan if you have federal loans from prior to 2007. I have $25K in federal loans from 2001, then took out $135K for law school from 2009-2012. Based on that, it looks like I wouldn’t qualify for PAYE. Do you know if I paid off the pre-2007 loans if I’d then qualify for PAYE?

I really am at an impasse as to whether or not to even attempt to pay these loans off or just wait for forgiveness, especially since my loans are currently negatively amortizing to the tune of $5K per year. I have general control over my salary, so I can adjust my AGI to a certain extent to maintain my IBR or PAYE if I ever qualify. Heck, I could even figure out what maximum salary I could make and still maintain my Income Driven Plan so as to be able to maintain my eligibility for forgiveness after 20 or 25 years. I would greatly appreciate any insights you could offer, especially since you are acutely aware of the seemingly insurmountable student loan debt that those of us with a professional degree possess.

Some Ground Rules to Keep in Mind

If you are in the private sector there are a few details that must be understood.  The biggest thing to keep in mind is that even if the Department of Education forgives your student loan debt, the IRS may see things differently.  The IRS defines debt forgiven as taxable income, meaning if 100k in student loan debt is forgiven, you will be billed on an extra 100k in income for that year.  However, if you are working towards public service forgiveness, the IRS issue does not apply.  Public Service forgiveness is free and clear.

That being said, there is support to modify the public service forgiveness program to have a cap, and there is also support to eliminate the taxation on the forgiven debt under IBR.  As a result, the student loan landscape and rules of the game may be much different in the near future.

Figuring Out the Right Repayment Plan

For this new lawyer, the first question is getting signed up for the proper repayment plan.  Based upon the age of the loans, it looks like they will only qualify for IBR, instead of the new improved PAYE.  Paying off the pre-2007 loans won’t help either, because they were on the books when you took out the loans post 2007.  Borrowers who took out loans after the PAYE cutoff are only eligible if they had a zero balance at the time they took out their first loan.  Unfortunately, there is nothing you can do to get on PAYE.

The good news on the PAYE front is that President Obama has taken steps to allow more people to sign up for PAYE.  At present, nothing has happened, but he did issue an executive order to broaden the policy.  We don’t yet know if any strings will be attached to the changes, but it is a situation worth keeping an eye on.

Looking Into the Crystal Ball

Unquestionably, there are a ton of variables at play here.  The law could change.  Your income could change.  Your expenses could change.  The better you can project these changes, the better you can do planning your repayment.

One thing to keep in mind is that just because you could qualify for student loan forgiveness, it doesn’t mean you should.  It is possible that you might spend more money going after forgiveness than you would if you just tried to pay off the loan.

If your loan balance is going up each year, it sounds as though making the entire balance disappear would be an enormous challenge.  At this rate, you best bet might be to just keep paying the minimum on IBR and to start saving now for a huge tax bill that you will get in about 20 years.  If the law changes, great, you now have a huge down payment for a house.  If it doesn’t, you will be prepared for the big bill.

What if I Make to Much?

The possibility of a huge salary increase is nice to have, but for financial planning, it can be dangerous to assume it is going to happen.  From a student loan perspective, you would need a really hefty salary to get kicked off IBR.  This is because IBR eligibility is determined based upon your total debt, not just your income.  You are eligible for IBR as long as your monthly payment on IBR would be less than your monthly payment on the 10 year repayment plan.

Assuming your interest rate is 6%, on the 10 year standard repayment plan, your bill would be $1921 each month.  The maximum income that would still be eligible for IBR would be around $170,000.

You can play with different salaries and loan balances using the federal government student loan repayment plan calculator.

If you are able to pay down your debt and make more money, you IBR eligibility may become a concern.  However, it is something that you will definitely see coming.  For now, file it away in the back of your mind as a problem that would be nice to have.  If your student loan balance is growing each year, there is little chance you will be getting kicked off IRB.

What is the plan?

If your federal student loan debt is growing faster than you can pay it down, student loan forgiveness may be your only way out.  With so many variables in play, the best thing you can do would be to keep making your payments and to set aside whatever money you can.  You may reach the point where it becomes clear you will be paying off your loan, and at that point you will have a pile of money to put a huge dent in it.  You may also end up getting a huge tax bill in the future, so you will be ready for that.  The best thing you can do is to make sure you are meeting all of the obligations on your loans and to financially prepare yourself for whatever the future holds.