The Good, the Bad, and the Ugly of the New Student Loan Forgiveness Program
March 26, 2015I recently received a panicked call from a friend of mine who had just graduated from graduate school with $120k of student loan debt. Since she had trouble making the payments, she signed up with the new “Pay As You Earn” student loan forgiveness program. Then she got an ugly surprise…
The Good: The Pay as You Earn program allowed her to only pay up to 10% of her discretionary income and have the remaining debt forgiven after 20 years.
The Bad: The amount forgiven will be fully taxable.
The Ugly: With her $100 a month payment and 6.5% interest rate (after a .25% reduction for using autopay), the amount forgiven would be about $359k. That would put her in the 33% federal income tax bracket plus almost 10.5% in state and local income taxes for about $150k in total taxes, which is more than she owed on the loan to begin with!
Fortunately, she had about $43k in savings and was wondering if she should use it to pay down the loan. We did the math and found that it would only save her about $59k in taxes. That’s less than a 2% return on her money over 20 years.
However, if she invested the $43k, earned just an average annualized return of 5%, (the stock market has earned over 5% in over 95% of 20 years periods since 1927) and added just $100 per month to it, she would have enough to pay the taxes off in full plus she’d still have a few extra thousand dollars remaining. Of course, if she earned more than 5%, she would have even more left over. If they change the law to make the forgiveness nontaxable, she will be able to keep the entire value of her investment. (On the other hand, if she pays down the loan and they change the law, she would be out of luck.)
What can we learn from this?
1) If you’re having trouble making student loan payments, see if you’re eligible for loan forgiveness programs like Pay As You Earn.
2) But be aware that you will be liable for taxes on the amount forgiven, which could be quite a lot of money depending on your loan balance, the interest rate, and your payment.
3) It might be tempting to use savings to pay the loan down but you’ll probably be better off by investing the money instead and using the power of compound interest to pay off the taxes after the loan is forgiven. This will you’ll also benefit if the tax on student loan forgiveness is repealed.
Needless to say, my friend felt much better after seeing the numbers. What most surprised me is that she had never even considered investing before this and didn’t realize how much her savings can grow if invested over a long period of time. It’s too bad her student loans didn’t pay for any financial education!