With all the talk out of Washington about possible mass student-loan debt forgiveness, it’s easy for borrowers to lose sight of the forgiveness options that already exist.
One important and often overlooked option is available to borrowers in all professions who are enrolled in income-driven repayment plans, which set monthly student-loan payments at an amount intended to be affordable based on a borrower’s income and family size. After 20 or 25 years, depending on the plan, borrowers can have the remainder of their federal student-loan debt forgiven. At present, the remaining balance is considered taxable income, though this is poised to change—at least for the short term—with the Covid-19 relief bill working its way through Congress.
Does it make sense for borrowers to try for this type of forgiveness by paying only the monthly minimum? Or would borrowers with extra cash be better off paying down their loans more aggressively?
There is no one-size-fits-all answer, but here are a few things to consider:
How do I qualify for income-driven repayment forgiveness?
There are four income-driven repayment plans offered by the federal government, and most federal student-loan borrowers are eligible for at least one, according to the U.S. Education Department’s Federal Student Aid office. Under these programs, borrowers might not have to make monthly payments at all if their incomes are low enough. But it also could be that borrowers in some cases end up paying more than they would under a standard 10-year repayment plan, based on their income and other factors.
Borrowers in any of the four income-driven plans who have a loan balance at the end of the repayment period are eligible to have that debt erased. There is no requirement that they work in public service or have a permanent disability, for example.
Is forgiveness under an income-driven repayment plan right for me?
Borrowers who qualify for the public-service loan forgiveness probably would be better off seeking relief through that program. They won’t owe taxes on the forgiven amount and loans under the PSLF program are eligible for forgiveness after 10 years of qualifying payments, rather than 20 or 25 years. There also could be other forgiveness options available from the federal government that are more appropriate to a borrower’s situation.
Meanwhile, those who have the money to pay off their loans early might benefit from doing so because holding out for forgiveness could end up costing them too much in interest and taxes, as things now stand. Others might prefer to pay off their debt sooner for reasons that include lowering their debt-to-income ratio.
But for borrowers buried under a mountain of debt, it can make sense to go for the lowest payment possible through an income-driven repayment plan, and stick with it until they eventually qualify for forgiveness, says Michael Lux, founder of the Student Loan Sherpa, a website focused on student-loan education, strategy and borrower advocacy. However, borrowers need to remember that, under the current rules, they will owe taxes on the forgiven amount—and that bill could be steep.
For example, it isn’t uncommon for people, especially those with a low income relative to their debt, to have a six-figure student-loan balance at the end of 20 or 25 years, says Tobin Van Ostern, co-founder at Savi, a service that helps student-loan borrowers determine their best repayment options.
Depending on the amount of debt that is erased, forgiveness also could push borrowers into a higher tax bracket, further increasing their tax burden. “You need to make sure you’re saving enough to pay for that tax hit,” Mr. Van Ostern says.
The tax ramifications, of course, are poised to change, at least through 2025, as part of the pandemic-relief package. Borrowers considering income-driven repayment forgiveness should be sure to stay up-to-date on these and other legislative developments.
Borrowers who have the money to pay down their loans more aggressively can use the federal government’s Loan Simulator, available at studentaid.gov, to determine how much more in interest they would pay by stretching out payments. There also are online services such as Savi and Summer that work directly with borrowers or through their employers to help with these decisions.
Those who are less confident about their finances might want to pay the minimum monthly amount under an income-driven repayment plan and set aside any extra money in a special savings account, Mr. Lux says. That way, if they decide to get more aggressive about payments, they will have funds available. And if they decide to ride it out and seek forgiveness on the balance, they will have money for the tax bill, he says.
Should I rethink my payment strategy given the current environment?
Since Washington has frozen payments and interest on many federal student loans through September, it may not be worth it to aggressively pay down this kind of debt right now.
Many borrowers might be better off putting the money they would have spent on these payments into a high-yield savings account and letting it grow, Mr. Lux says.
There’s also the possibility that some amount of federal loan debt will be canceled. President Biden has indicated he is leaning toward $10,000 of federal-loan forgiveness per borrower through Congress, whereas some Democrats are pressing for $50,000 through executive order, a proposal that hasn’t garnered presidential support.
If this is still in limbo once the payment pause is lifted, some borrowers may want to pay only the minimum and take the chance this additional forgiveness will materialize, Mr. Lux says. For others, however, the cost of letting the interest linger could make that a bad bet.
“The extra interest that you pay, hoping for forgiveness, is the cost of the bet,” Mr. Lux says.
Another unknown is how various efforts to change the current system of income-driven repayment will play out. Among other things, student-loan advocates would like the tax burden associated with income-driven repayment forgiveness eliminated. Indeed, a provision in the Senate version of the Covid-19 relief plan passed Saturday would eliminate any tax consequences for households whose student debt is forgiven through 2025.
In any case, borrowers are advised to discuss their options with their loan servicer before making any changes to their payment strategy. Plan to do this before the payment freeze ends because, once it does, servicers are likely to be swamped, Mr. Lux says.
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