Frequently asked financial questions are questions that I’ve seen pop up over and over again. I thought I’d take the time to answer them in this new Series.
So each post will have a short quick answer to these frequently asked financial questions followed by a longer more detailed answer.
Will my student loans really be forgiven?
Lots of student loan borrowers take advantage of income-driven repayment plans for federal loans and think that at the end of it any loans they have left will be forgiven.
In my case and in the case of many of my friends, the reason for using income-driven repayment plans is because it’s all we can afford. It can be extremely frustrating because my payments each month do not even cover the interest. Which means, my loans are growing, I’ve made payments for nearly 6 years and owe more now than when I graduated. But at least at the end of 25 years, my loans will be forgiven, right?
Not really, unless you are looking to have them forgiven through the public service loan forgiveness program in which case yes, after 120 qualifying payments the remainder is forgiven. The other federal income-driven repayment plans require the forgiven amount after the 20-25 years be considered taxable income.
This means that if, like mine, your student loans are growing, after 20-25 years you are going to have a big effing tax bill. You can use the Student Loan Hero Dashboard to find out what your approximate tax liability might be.
Income-Driven Repayment plans calculate a loan borrower’s monthly payment based on their income. How they are calculated depends on the income-driven repayment plan. There is Income-Based Repayment (IBR), Income-Contingent Repayment (ICR), PAYE, and REPAYE. The monthly payment amount for all of these repayment plans falls somewhere between 10%-20% of your discretionary income.
Discretionary income for IBR, PAYE, and REPAYE is defined as: Your income – (150% x poverty guideline) = discretionary income For example, Let’s say I make $50,000 per year. As a family of just me (1) the poverty guideline is $12,060.
My discretionary income is: $50,000 – (1.5 x 12,060) = $31,910 So my monthly payment would be between 10% – 15% of $31,910, or $265.92 – $398.88 per month.
Discretionary Income for ICR is defined as: Your Income – (1 x poverty guideline) = discretionary income. Sticking with the example above, my discretionary income would be: $50,000 – (1 x $12,060) = $37,940
Meaning my monthly payment of 20% of my discretionary income would be: $632.33
If you have private loans or your debt to income ratio allows, consider refinancing with a company like SoFi. I wrote a review about my experience refinancing my bar loan with SoFi. Refinancing with SoFi ended up saving me over $1k. Use one of my links to refinance and you’ll get a $100 bonus.
The problem with Income-Driven Payment Plans
The downside of income-driven repayment plans is that your monthly payment may not even cover the amount of interest that accumulates on the loans. This means that your loans are increasing.
Keeping with the example above, let say I have $125,000 of student loan debt an interest rate of 7.5% (though you know I owe more than that).
$125,000 x 7.5% = $9,375 per year
$9,375/12 = $781.25 per month
That $781.25 per month is more than what I would pay on any of the income-driven repayment plans. Which means my loans would grow each month, likely by hundreds of dollars.
If this continues for 20-25 years, you can imagine the amount that would be “forgiven” at the end of the repayment term.
While I may have started with $125,000 at the end of 20-25 years it could be $250,000. $250,000 would be forgiven and considered taxable income. So I would be taxed as if I made an additional $250,000 that year. Which given current tax rates would be a minimum tax bill of $66,029.25 not including your regular income.
After making payments for 25 years, say using IBR 15%. You would have paid a total of $119,000 and you would still have to pay an additional $66k in one fail swoop. You must decide whether you are going to work like hell to increase your income and actually pay off the loans before they would be “forgiven” or do you save and prepare yourself for that tax bill?
Wrapping it Up with a Bow on Top
Your student loans will be forgiven tax-free if:
- You qualify for the Public Service Loan Forgiveness program
Your student loans will be forgiven BUT considered taxable income if:
- You qualify through IBR
- Your qualifying through ICR
- You qualify through PAYE
- Your qualifying through REPAY
Read more from the Frequently Asked Financial Questions Series.