Study the Details to Ace Student Loan Forgiveness

Now is nail-biting season for high school seniors as they wait for acceptance letters from colleges.

And, since most kids aren’t budding Nobel Prize or Heisman Trophy winners, now is also a stressful time for parents as they try to figure out the best way to finance a college education that can cost more than the family home.

In most cases, covering the cost of college means cobbling together current income, savings and various types of loans like a home equity line of credit, loans made directly to students and parental loans.

Before accepting any loan, students and parents need to do some homework and evaluate the pros and cons of what’s available. Some loans come with more attractive repayment options and even total debt forgiveness. But there are always requirements to qualify, so it’s best to know what’s necessary before signing an agreement.

The federal government offers two loan repayment programs that reduce the amount a student has to pay back each month to help grads make ends meet. The Income-Based Repayment plan (IBR) has been around for a few years and the Pay As You Earn (PAYE) plan was just introduced last December. Both reduce a borrower’s monthly payment by adjusting it to his/her post-college income.

While anyone can apply for their student loans to be converted to the IBR or PAYE plan after graduation, to qualify a loan must be:

1. A “direct” federal loan from the Department of Education, as opposed to a private lender
2.  Issued to the student- not mom and dad
3.  Funded after a certain date. (1) Multiple student loans that meet these criteria can be consolidated.

To qualify, the graduate must demonstrate that it would be an economic hardship to have to re-pay the loan under the “Standard Loan” plan, which requires that the loan be repaid over 10 years, without any consideration of the size of the monthly payment.

In contrast, both the IBR and PAYE programs reduce the monthly amount due by extending the repayment time. The IBR offers 25 years to repay an outstanding balance, while the PAYE program extends the period to 20 years.

The criteria for qualifying for these plans is straight forward: it’s based on post-graduate adjusted gross income (“joint” AGI if for married folks), family size, state of residence and other information. If a monthly payment is less than what it would be under the 10-year “standard” repayment plan, it’s likely to qualify. (The links at the end of this column to both the IBR and PAYE programs will take you to a simple calculator so you can see where you stand.)

The downside is that stretching out the re-payment period means grads could pay more in interest. However, in periods when the monthly payment based upon income doesn’t cover the full amount due (known as “negative amortization”), the interest that builds up is not added to the principal of the loan.

While all of this sounds dandy, as with many things, the devil is in the details. For instance, the graduate/borrower must submit proof of income every year because the loan is reviewed (and potentially adjusted) on an annual basis.

“To remain in the program, a borrower needs to submit annual documentation to their loan servicer about their income and family size, most commonly by providing a copy of their most recent IRS income tax return [to their loan holder.]… If his or her income increases or decreases, there will generally be a corresponding increase or decrease in the required monthly payment amount,” explains As explained by Sara Gast, a spokeswoman for the Department of Education.

Furthermore, while Uncle Sam understands that making loan payments--even reduced ones--can be difficult at times, he expects grads hold up their end of the deal.. It would be a major mistake to pay less than the amount required or perhaps skip a payment entirely because it could negate the biggest benefit of these reduced payment programs: loan forgiveness.

Borrowers that make 25 years under the IBR program or 20 years under the PAYE program of “complete, on-time payments” and remain in good standing, Gast says any balance owed can be wiped out.

For example, a grad with an entry-level job after law school that pays pittance could qualify for reduced monthly loan payments. Then, after a few years, the borrower is sitting in the junior partner suite. The paycheck that comes with the promotion will change the loan terms as there is no longer a “hardship” to pay the repay the student loans. After reviewing the annual financial information stating the new income, a lender will increase the monthly payment to where it would have been under the “standard” 10-year loan repayment plan. However, you can- and should- remain in the IBR/PAYE program.

Staying in the program is critical because, according to Gast, even if a person no longer has a financial hardship, “as long as you remain [in the plan] and you otherwise meet the requirements (i.e. making full and on-time payments), you will qualify for forgiveness of any remaining loan balance at the end of the 25-year period.”(2)

Want to wipe out student loan debt even faster? Get a full-time job in public service after college. This includes work for a government entity at any level or for a non-profit organization. Workers that also qualify for one of the approved repayment plans such as IBR, PAYE or even the 10-Year Standard Repayment Plan and make monthly payments  in full and on-time for just 10 years and then apply to the “Public Service Loan Forgiveness” program (PSLF). If they are approved, then poof, any outstanding balance is cancelled.

Regardless of the program under a loan is forgiven, it’s important to know that for those working in the private sector, the amount of college debt that is cancelled is taxable as income. In contrast, it is tax-free for those working in the government or in the non-profit world. “For those who get to the point in life that they think their debt is forgiven, they might be surprised by the tax bill they have to pay,” says certified public accountant Gary Carpenter.

For instance, take the doctor who comes out of med school with a quarter of a million to $400,000 in debt. Suppose this individual went into private practice and after 25 years still had outstanding student loan debt of, say, $100,000. While this debt would be forgiven, s/he would owe income tax on this amount. On the other hand, if this doctor worked for a public hospital, the debt would be cancelled and there would be zero tax on the amount. Sweeeet!

Eligibility for student loan debt cancellation is not necessarily lost if, as Gast explains, life intervenes. Take, for instance the case of a teacher who graduates with a master’s degree and works in a public school for three years, dutifully paying back her loan under one of the applicable programs. Then, she takes a year off to care for a new child and stops paying on her loan. When she returns to teaching, she resumes her monthly payments.

According to Gast, this individual would still be eligible to have her loan cancelled under the Public Service Loan Forgiveness program. “The payments do not need to be consecutive, and for some borrowers, 120 qualifying payments may take longer than 10 years.” For more information about PSLF, go here. You’ll also find a form to help borrowers keep track of their payments in order to, in Gast’s words, “make it easier to apply for forgiveness down the road.”

A final thought: When I told friends about these programs the response I often got was, “But we don’t want to saddle our son/daughter with paying off the entire cost of college.”  That’s fine. If the loan is in the student’s name, there’s nothing that prohibits mom and dad from giving the money to their child to cover part or all of the monthly payment.

1. A thorough explanation of terms and conditions for the IBR and PAYE programs can be found here and here

2. 20-years under the PAYE program.

3. For complete details, visit here