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How Does Student Loan Forgiveness Affect Your Finances?

If you’re buried under a mountain of student loan debt, having it forgiven can be a huge relief. Forgiveness is generally possible if you’re disabled, part of one of the income-based repayment options or pursuing a career in public service. While getting your loans wiped out in one fell swoop can seem like a lifesaver, it may come with some negative financial implications.

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Loan Forgiveness and Your Credit

Generally, when a student loan is forgiven, it shouldn’t impact your credit in a negative way. As long as your loans were in good standing at the time they were discharged and your accounts are being reported properly to the credit reporting bureaus, you won’t see a huge difference in your score.

How Does Student Loan Forgiveness Affect Your Finances?

On the other hand, you could see your score drop if your account wasn’t in good standing prior to the discharge. For instance, if you fall behind on your loans because you become disabled, your loan servicer will report the missed payments on your credit. Once the loan is discharged the balance will show up as zero, but your lender isn’t required to remove the previous negative credit history.

If your loans have been discharged and the accounts aren’t being reported properly on your credit, you have the right to dispute anything that’s inaccurate. Thanks to a recent settlement, the credit bureaus are now more inclined to investigate and correct any errors in a timely manner.

Tax Treatment of Forgiven Debt

Aside from potentially damaging your credit, student loan forgiveness can complicate your tax situation. The IRS views forgiven debt as taxable income unless it meets specific exemptions or exclusions. Exceptions are made for student loans that are forgiven, but it’s only for borrowers who are participating in certain programs.

For instance, if you’re going through the federal Public Service Loan Forgiveness or Teacher Loan Forgiveness programs, you won’t have to pay taxes on anything that’s written off as long as you meet all of the requirements. On the other hand, if you’re on the Income-Based Repayment plan, the amount that’s leftover after you hit the 25-year repayment mark would automatically be forgiven but you’d have to report it on your taxes.

That creates a kind of catch-22 for borrowers since you have to maintain a lower salary to stay on an income-dependent repayment plan. If you can’t pay, that opens the door to even more problems in the form of tax penalties and interest or even a lien, which can be devastating for your credit.

Other Problems With Loan Forgiveness

How Does Student Loan Forgiveness Affect Your Finances?

Before seeking forgiveness for your loans, there are a few things to keep in mind. For one thing, it isn’t guaranteed. With the Public Service Loan Forgiveness program, borrowers are required to work in public service for 10 years and make on-time payments during that time to qualify. That sounds easy enough, but since it’s a federally-funded program, there’s always the possibility that it could be shut down. If that happens, you’ll still be stuck paying those loans.

The other issue is that it can cost you more money in the long term. Someone who owes $30,000 in loans with a 6 percent interest rate would have to pay about $333 a month on the standard 10-year plan and the total interest would come to just under $10,000. If you’re making $30,000 a year, you could qualify for IBR. After 15 years, your loans could be paid off, but you’ll have paid a larger amount of interest in the process. That’s something that you can’t afford to overlook.

Photo credit: ©iStock.com/Steve Debenport, ©iStock.com/Courtney Keating, ©iStock.com/eternalcreative

Rebecca Lake Rebecca Lake has been writing about the nuts and bolts of personal finance for nearly a decade. She is an expert in investing, retirement and home buying topics. Her work has been featured on The Huffington Post, Business Insider, CBS News, U.S. News & World Report and Investopedia. As a homeschooling mom of two, she's always looking for ways to make the most of every dollar.
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