Student Loan Debt Relief: Recent Changes Advisors Should Know

Analysis February 22, 2021 at 05:00 AM

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Rising college costs and low borrowing restrictions on student loans mean that many young clients and their parents are struggling with education debt. Advisors need to be aware of changes brought about by the CARES Act and other legislative actions taken in 2020 that provide some relief for borrowers.

One form of relief came through the suspension of payments on federal loans held by the Department of Education. The suspension period was originally set to apply from March 13, 2020 to Sept. 30, 2020, but was subsequently extended to Sept. 30, 2021. During this period, payments were automatically stopped for borrowers with qualifying loans.

Another form of relief came from dropping interest rates to 0% on these same loans. This sounds straightforward, but advisors need to be aware that there are really three primary types of loans: federal loans, private loans, and hybrid federal/private loans offered through the Federal Family Education Loan (FFEL) Program.

The emergency relief benefits apply only to borrowers with federal loans held by the federal government, and do not apply to the majority of federally backed FFEL loans issued by private lenders before 2010.

Borrowers With Existing Federal Student Loan Debt

The CARES Act greatly benefited those with PLUS loans, which generally carry higher interest rates, and those working toward loan forgiveness under either one of the income-driven repayment (IDR) plans such as Pay As You Earn (PAYE) or Income-Based Repayment (IBR), and those working toward loan forgiveness under the Public Service Loan Forgiveness (PSLF) program.

An interest waiver is worth most to borrowers whose loans have higher interest rates and those who are still able to pay during relief periods.

For those borrowers working toward loan forgiveness, the 10-month suspension of payments will count as if qualifying payments were made toward the 20- or 25-year repayment period for borrowers in an IDR plan and 10 years under PSLF.

Under the current rules, borrowers who are working toward PSLF and were still able to make payments during relief periods were better off not making them since this would reduce the value of the tax-free loan forgiveness they are working toward.

In a nutshell, borrowers who aren't working toward or planning on forgiveness should make payments during grace periods and when interest waivers are available to reduce the overall cost of borrowing, while those who are working toward forgiveness may be better off investing their funds elsewhere to maximize the value of loan forgiveness, whether it is tax-free as is under PSLF or taxable as it currently stands for IDR forgiveness.

Borrowers With Private Student Loans or FFEL Loans

Unfortunately, emergency relief did not apply to holders of private and most FFEL loans. Borrowers of FFEL loans may have considered consolidating their loans using a direct consolidation loan to benefit from the relief measures, but consolidating takes time and could have also jeopardized the borrower's ability to qualify for loan forgiveness.

Consolidating can be a good thing and can make borrowers eligible to participate in certain IDR plans and work toward forgiveness under PSLF, but one instance in which consolidating could be detrimental is when the FFEL loan borrower has already made a significant amount of qualifying payments under the income-based repayment (IBR) plan.

This is because IBR is the only IDR plan for which FFEL loan borrowers can receive forgiveness. When a borrower consolidates into a direct consolidation loan and enrolls into an income-driven repayment plan, the 20- or 25-year repayment clock resets!

Knowing which type of loans the borrower has (federal or private) and distinguishing the lender from the servicer are critically important when advising on student loan matters.

While a borrower may have wanted to benefit from the short-term relief provided by the CARES Act and recent legislative actions, not fully understanding the options available and their consequences could potentially cost the borrower much more in the long run.

And while private loan borrowers did not receive standardized relief under the CARES Act, many private lenders have offered some form of relief for borrowers primarily through forbearance as opposed to interest rate waivers.

This means that even if the borrower were not forced to make payments over a short period of time, interest on these loans would still accrue and increase the cost of borrowing over time.

Despite the lack of standardized relief, many private loan borrowers can take advantage of today's low interest rates. Borrowers holding loans with higher interest rates should consider refinancing, assuming their credit is good enough and they weren't affected economically by the pandemic.

For employees who aren't able to secure better rates on their loans, it is possible their employers might start chipping in now to share some of the cost.

Under the CARES Act and from recent legislative authority, employers are now able to establish an education assistance program under IRC 127 to help repay principal and interest on qualifying loans for employees. Up to $5,250 per year (through 2025) of assistance is deductible by the employer and excludable from the gross income of the employee.

This has become an increasingly popular tax-efficient employee benefit used to retain skilled workers, and advisors should become more familiar with enhanced education-related tax benefits for both employees and business owners.

Borrowers With High-Interest-Rate Federal Loans and Prospective Borrowers

What about borrowers who hold federal loans with higher interest rates, as is the case with many graduate and parent PLUS loan borrowers? What about prospective students and parents considering financing options for later this year or in future years?

Let's tackle the current borrowers first. The main thing these borrowers need to determine is which benefits are most valuable to them.

Do they value the repayment plan flexibility and ability to have monthly payments tied to their "ability to pay"? Do they value the prospect of the government stepping in to provide sweeping emergency relief? Do they plan on receiving loan forgiveness based on their current and projected debt-to-income ratio? Or are they planning on repaying quickly and value obtaining the loan with the lowest interest rate possible?

In addition, advisors need to know which type of borrower they are working with: Undergraduate students? Graduate students? Parents?

It may be worth it in the long run to refinance high-interest-rate federal loans using private loans (and forgo the benefits) if the primary objective is to repay the debt as quickly as possible, the borrower has the means to do so, and the borrower does not plan on working for a qualifying public service organization.

It is important to remember that borrowers can refinance a federal loan to a private loan, but they cannot go the other way or revert back once this occurs.

The decision may be simpler for prospective borrowers since federal loan rates change each year and are based on the high yield of the last 10-year Treasury note auction in May, so prospective undergraduate federal loans borrowers generally receive the lowest rates (currently, 2.75%).

Undergraduates, however, aren't often the ones accumulating massive amounts of debt due to federal borrowing limits. We typically see six-figure student debt totals among graduate students and parents.

A popular form of financing for this group is the federal PLUS loan. This loan, often referred to as a Grad PLUS or Parent PLUS loan, is available to graduate students and parents of undergraduate students at higher interest rates — currently 5.30% until June 30, 2021.

These loans also impose origination fees of over 4%, have essentially no borrowing caps, and require that the borrower have no "adverse credit history."

Advisors will need to determine whether it's better to borrow through the PLUS loan system or the private market by comparing interest rates and other loan costs as well as repayment plan options. This requires an understanding of the borrower's projected future earnings to evaluate whether loan forgiveness will be a realistic option.

Generally speaking, federal student loans provide more flexibility and benefits than private student loans. President Joe Biden has also proposed several new changes that will affect both prospective and existing student loan borrowers, including proposed revisions to the IDR plan system and enhancements for borrowers working in public service and pursuing forgiveness under PSLF.

Revised Income-Driven Repayment

According to Biden's post-election website, "Individuals making $25,000 or less per year will not owe any payments on their undergraduate federal student loans and also won't accrue any interest on those loans. Everyone else will pay 5% of their discretionary income (income minus taxes and essential spending like housing and food) over $25,000 toward their loans."

While this may sound great in theory, several important details are left out.

First, will the $25,000 threshold change based on family size as well, or will family size affect only the calculation for discretionary income purposes? If no adjustment is made, this proposal favors borrowers without families who are under that threshold.

There is also some ambiguity as to who the "everyone else" is in that statement regarding being subject to payments based on 5% of their discretionary income. What about parents who borrowed on behalf of undergraduate students? What about graduate students? Are they included in this "everyone else" category?

The website also states that new and existing borrowers will be automatically enrolled in the income-based repayment program.

The proposal does not clarify whether this applies only to undergraduate loans, which will create even more complications when working with clients who have both undergraduate and graduate federal loans and are already on a repayment plan.

Will the undergrad loans be subject to the 5% calculation while the grad loans remain subject to the 10% or 15% discretionary income calculation? What about students who consolidated their undergraduate and graduate loans together?

The automatic enrollment provision may also create a situation similar to employer-sponsored retirement plans where individuals don't realize they may be better off contributing more to pay off the loans more quickly and save on interest. While the automatic enrollment feature will be helpful for most, it may have an anchoring effect on other borrowers.

One thing that is likely to pass is making forgiveness from IDR plans tax-free, similarly to how balances are treated under the PSLF program. Most borrowers who will receive a substantial amount of forgiveness under the current IDR plan system probably won't be able to pay the lump-sum tax bills in the year of forgiveness.

This provision in the tax code would also likely apply to borrowers on all IDR plans, and not just those enrolled in Biden's newly proposed version of IBR.

Reworking PSLF

Working in public service would become even more attractive under Biden's plan. The existing system would likely be enhanced to include loans that don't currently qualify, such as FFEL loans.

In addition, some form of accelerated forgiveness may be added to the current PSLF program, either the existing 50% after five years and/or up to $10,000 per year over five years from recent proposals.

The success rate under the PSLF has been abysmal. Many borrowers assume they are on track to receive forgiveness under PSLF when that hasn't been the reality.

While enhanced flexibility is likely in the future, it's still best for advisors to confirm three pieces of information with their clients: that they are making payments on qualifying loans, are on a qualifying repayment plan, and that they are working for a qualifying public service organization.

Making sure borrowers check these three boxes can only help them regardless of what future proposals are enacted. While other proposals are being considered that are designed for lower- and middle-class borrowers, working toward PSLF should still remain a viable strategy for borrowers across the wealth spectrum.

Despite the uncertainty of future education policy, the best thing advisors can do is start to develop client profiles. Middle-income clients will have a different set of borrowing options than high-income clients, and it is important to develop a set of strategies for each group.

Although future policy changes are still up in the air, it's important to consider taking advantage of legislation that provides relief for some borrows, plan for future education expenses, and take advantage of opportunities to refinance certain types of debt at a lower interest rate.

Ross Riskin is a associate professor of taxation at The American College of Financial Services.

Michael Finke is a professor of wealth management at The American College of Financial Services.

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