If $10,000 vanishes from your student debt, you may want to celebrate.
But what does that mean for the rest of your financial life?
This is a question millions of student loan holders may be facing soon if President Joe Biden proceeds with a controversial plan to cancel $10,000 in federal student-loan debt per borrower with an executive action.
The details of this answer are going to touch a borrower’s day-to-day budget, their credit score and potentially their taxes too, financial experts say.
The Biden administration is reportedly considering a plan to forgive $10,000 in federal student-loan debt per borrower for people making up to $150,000 and married couples filing jointly that earn up to $300,000, the Washington Post said, citing sources familiar with the discussions.
“Supporters say borrowers badly need relief from a crisis connected to soaring education costs that have taken a toll on family budgets. ”
Americans have approximately $1.6 trillion in student-loan debts, according the Federal Reserve Bank of New York. Payments on federally-held loans have been on pause since the pandemic’s start in March 2020.
On Wednesday, the administration cancelled federal student-loan debt for more than 560,000 defrauded borrowers who attended the now-defunct Corinthian Colleges. The government cancelled $5.8 billion, in the Education Department’s largest single loan discharge.
Widespread cancellation would carry a larger price. Forgiving $10,000 per borrower would cancel a total of $321 billion in debts, according to an April analysis by New York Fed researchers. A $10,000 cancellation would extinguish the debts of 11.8 million borrowers, researchers said. It would also end the obligations for 30.5% of student loans that were delinquent or in default status ahead of the payment pause, the analysis said.
“ Opponents say forgiveness is an unfair bailout and a Pandora’s Box opening up questions on who else should or shouldn’t get debt relief.”
Last year, the median student-loan debt hovered at between $20,000 and $24,999, according to Federal Reserve research released in May. (The findings on household economic well being were based off a fall survey of more than 11,000 people.)
Make no mistake, student-loan forgiveness, whatever the method or amount, is a divisive idea.
Supporters say borrowers badly need relief from a crisis connected to soaring education costs that have smothered too many family budgets. Opponents say it’s an unfair bailout and a Pandora’s Box opening up questions on who else should or shouldn’t get debt relief.
There are winners and losers in this debate. Love it or hate it, if any kind of cancellation comes, the financial landscapes for millions of people are poised to change. It may change them completely, or it may be “a drop in the bucket.”
Here’s a guide to those potential changes and the best ways to handle what could happen next:
Household budgets
Financial planner Savon Gibson has already been talking to clients about what happens to their budgets if $10,000 in federal student-loan debt gets cancelled. It’s about identifying the “next biggest debt” or the “next biggest priority,” where the suddenly freed-up money can go, said Gibson, the owner and managing director of Gibson Financial Planning in Cincinnati, Ohio.
To be clear, Gibson cautions clients against assuming cancellation will occur. But if happens, he wants them already thinking about their next move.
Many of Gibson’s clients hold between $20,000 and $40,000 in student loans, so $10,000 of relief would be “substantial.” Around 20% of Gibson’s clientele has been tucking aside money for student-loan payments, while many others have applied the would-be payment money elsewhere.
“Freeing up $10,000 could enable people to build up emergency savings or pay down high-interest debt like a credit card.”
If cancellation happens, Gibson said the budgeting question becomes “where will the funds have the most impact?” There’s no one answer. It could involve building up emergency savings or paying down higher-interest debt, like a credit card, at a faster pace as interest rates rise, Gibson noted.
For people who have been putting money aside — and who are likely already inclined to pay debts and save — Gibson said they could be putting the lump sum towards long-term goals, like retirement accounts or extra mortgage payments.
Around seven in ten borrowers making regular payments before the pandemic pause say they can afford to resume payments, according to a Federal Reserve Bank of Philadelphia survey released in May.
But 92% of employed borrowers were worried about affording revived payments in a time of high inflation, in a February survey from Student Debt Crisis Center, an advocacy group.
Credit Scores
Credit scores always matter. But in a time of rising interest rates meant to counter hot inflation, “it’s especially important to maintain a healthy credit score,” said Bruce McClary, spokesman for the National Foundation for Credit Counseling, a nonprofit financial counseling organization. Lower scores mean even more expensive borrowing costs, and that’s the last thing someone needs when so many other prices are increasing, he explained.
Credit scores are supposed to offer a glimpse at how reliable a person is at repaying their debts, but McClary said it’s not a given that suddenly having less student-loan debt automatically leads to a better score.
Of course, $10,000 forgiveness “could set in motion events and circumstances leading to higher scores.” That would happen, for instance, if money otherwise intended for student loans can now go towards high credit-card balances.
“Financial advisers caution that it’s not a given that suddenly having less student-loan debt would lead to a higher credit score.”
“Ultimately, that would improve their debt ratio and help raise their credit score as those credit card balances drop,” McClary said.
“Given the uncertainties, it’s too early to say how individual consumers’ credit would be impacted,” said Margaret Poe, head of consumer-credit education at TransUnion TRU, -1.44%, one of the three major credit-reporting companies.
Scores are created with factors like “payment history, your balances or how much you owe, age of your credit history, new credit and the different types of credit you have, also known as your credit mix,” Poe said. Plus, the ratio of your debt to your credit limit.
When a person has student loans, “they add to your credit mix, which can help your score over time. Making on-time payments can also help build healthy credit. However, if you pay off and close a student loan, your credit mix may become less diverse, which could lower your score,” Poe said.
Still, she added, “paying off student loan debt in full as efficiently as possible is a smart move for your financial health.”
Taxes
Typically, cancelled debts snuff out re-payment obligations to the lender, but they spark a tax obligations to the Internal Revenue Service. That’s because the IRS generally views the amount of cancelled debt as income.
Yet borrowers are going to avoid an upcoming tax surprise if Biden goes ahead with forgiveness, experts say. They might just need to plan for extra state income taxes depending where they live.
Tax-code exceptions already exist for student-loan forgiveness. For example, people who get their student loans wiped away through the Public Service Loan Forgiveness program, such as teachers and nurses, do not face extra federal taxes for their cancelled debts.
Until recently, the cancellation of debt-tax exceptions didn’t apply generally to borrowers, said Matthew Chingos, vice president of education data and policy at the Urban Institute, a left-leaning think tank.
“The American Rescue Plan exempted student-loan cancellation from paying federal tax on that forgiveness through 2026. ”
The March 2021 American Rescue Plan changed that, exempting student-loan cancellation from federal cancellation of debt tax provisions through 2026. Democratic lawmakers were thinking ahead about the chance of loan cancellation and preventing student-loan debt from becoming tax debt, Chingos said. “The goal of that change was to take this problem off the table,” he said.
It makes no difference for tax purposes if the student-loan debt is cancelled through executive action or a Congressional law change, Chingos said. Without the tax provisions, a borrower making at least $122,000 a year would have faced an extra $2,400 in federal taxes, according to Chingos’ research. Someone earning less than $25,000 a year would have faced an extra $800 in federal income taxes, the calculations showed.
But borrowers in some places might face state-level income taxes for the debt cancellation, according to Susan Allen, senior manager of tax practice and ethics at the American Institute of CPAs.
Tax laws in approximately 20 states would follow federal law when it comes to the tax treatment of student debt cancellation, Allen said. Connecticut and Maryland are two examples. But the tax laws in roughly 15 states, including New Jersey and Mississippi, have potentially open questions on the issue, she added.
That’s where it’s important to do homework or check with a tax professional if the cancellation does happen, Allen said. “Each state would have different nuances to check out.”