Why Debt Payments Will Actually Increase Under Senator Elizabeth Warren’s Loan Forgiveness Policy

With the 2020 presidential election underway, a few of the candidates have started addressing the mounting cost of higher education by presenting distinctive policy proposals on student loan debt. For example, Massachusetts senator Elizabeth Warren recently unveiled a proposal that would cancel up to $50,000 in student loan debt balances for households with annual incomes under $100,000, and certain limitations for incomes above this threshold. She also subsequently released a calculator to help borrowers assess how much of their student loans would be forgiven under the plan. While in theory this sounds nice, it is becoming increasingly apparent that politicians don’t possess a modicum of understanding on how student loans, repayment plans, and forgiveness actually works. If one essentially runs the numbers, many student loan borrower’s monthly debt payments will actually increase under Warren’s forgiveness policy.

Here’s how

It is becoming increasingly common to see student loan balances in the six figures, so let’s use an example of an individual who currently has $200,000 in student loans outstanding. Let’s say that person is making under $100,000 annually or $80,000 to be more precise. That individual is most likely on some type of income-based repayment plan, as the standard repayment plan would equate to a monthly payment of $2,322 (using an average interest rate of 7%) or almost 35% of their total income. So let’s say that individual turns to the Revised Pay As You Earn (REPAYE) plan to help them make their monthly payment more manageable. Under REPAYE, the monthly student loan payment would decrease to $432. Why? Because the payment calculation is based on discretionary adjusted gross income (AGI) of the borrower, NOT the actual student loan balance.

Herein lies the problem with Senator Warren’s plan

Under Senator Warren’s plan, the borrowers balance would decrease by $50,000. Now that individual’s outstanding balance has dropped from $200,000 to $150,000, which should decrease their monthly obligation, right? Wrong. Under REPAYE, the decreased balance does nothing to decrease the monthly payment. It would still be $432, again because it is based on discretionary income, not the actual student loan balance.

Now here’s the kicker

That $50,000 in forgiveness has disappeared into thin air, right? Wrong. When a debt obligation is forgiven, it is currently considered taxable income by the Internal Revenue Service (IRS). According to the IRS rules, any student loan forgiveness that is received must be reported on your tax return. The student loan provider will send that individual a Form 1099-C, showing the amount of cancellation of debt and the date of cancellation. Then that individual will be required to report this amount of canceled debt as ordinary income on Form 1040. At $80,000 in annual income, that would put an individual in the 22 percent tax bracket. Multiplying the 22 percent by the amount forgiven (0.22 x $50,000) would equate to tax bill of $11,000 that is due by April 15^th.

It’s been widely reported that many Americans don’t have $400 in savings to cover an emergency, let alone $11,000 lying around to pay for an unexpected tax bill. This means that an individual would be forced to go on a repayment schedule. Unfortunately, the IRS doesn’t allow repayments plans without additional penalties and interest. A tax obligation that is above $10,000 would also subject the borrower to a required minimum payment. With a maximum repayment term of 72 months, the $11,000 tax obligation would equate to a minimum payment of $152.78, plus a penalty at 0.25% of the balance added every month, plus a current interest charge of 6% compounded daily. The equates to an estimated monthly payment of $210. Let’s not forget, the borrower still owes the $432 a month in student loan payments based on REPAYE. Add the $210/month tax debt obligation, and now the borrower’s total monthly debt service has increased from $432/month to $642/month. This is almost a 50 percent increase!

Loan forgiveness is not a panacea

We need start getting real about student loan forgiveness by having honest, candid conversations around what that truly means for borrowers. The debt does not vanish, as some policymakers would like voters to believe. The policy will most likely turn student loan debt into another type of debt – tax debt – which is currently not forgivable, and may add to the debt burden that student loan borrowers are currently facing. Borrowers should avoid depending on political promises, and start talking to their student loan provider and ideally a CERTIFIED FINANCIAL PLANNER™ who specializes in student loans, to determine how student loan forgiveness will impact their personal financial situation.