Student loan payments are back. What to know about interest, loan servicers and taxes.
The three-year pause is over for an estimated 43 million borrowers, including 1.5 million Illinoisans. To help, we researched your burning questions.
Student loan payments are back. What to know about interest, loan servicers and taxes.
The three-year pause is over for an estimated 43 million borrowers, including 1.5 million Illinoisans. To help, we researched your burning questions.
By Lisa PhilipAn estimated 43 million federal student loan borrowers have to start making payments this month for the first time in three years. More than 1.5 million Illinois residents owe student debt, totaling $61 billion.
We asked listeners to share their hopes, fears and questions in the lead up to the end of this pandemic-era payment pause.
“The interest rates on my student loans are super-duper high and it always feels as if I am putting out a fire with my tears only,” wrote one borrower, Marco Colapietro, a high school counselor from Elk Grove Village.
To help dispel some confusion and anxiety, we answer your questions about interest, student loan servicers and whether a canceled student loan counts as taxable income (answer: It depends).
INTEREST
Why does the federal government charge student borrowers interest?
It’s a way to recover the costs of lending money.
“If the government lent money without charging interest, that would represent a cost because … they can’t spend it until it gets repaid,” said Sam Brunson, a tax scholar at Loyola University Chicago’s School of Law.
For instance, $1,000 lent to a student five years ago and repaid today would be worth less than its original value, due to inflation. If the government didn’t charge interest, it would have to cover that cost some other way.
“That might mean increasing the taxes, that might mean cutting other programs,” said Mark Kantrowitz, a writer and expert on college financial aid and scholarships. “Congress doesn’t want to do that, so it’s much easier for them to charge interest on it.”
Elizabeth Tandy Shermer, a history professor at Loyola, explained it another way.
“Your interest payments are replenishing for the next generation of students who need the money,” said Tandy Shermer, who wrote the book, Indentured Students: How Government-Guaranteed Loans Left Generations Drowning in College Debt.
Tandy Shermer said Congress came close to passing a broad undergraduate grant program in the 1950s, but the idea of giving money to students without charging them was considered un-American.
“The United States was unique in terms of getting high school to be universal, and also to have public schooling. And we’ve really fallen down on higher education,” she said. “It’s this habit and custom that you are supposed to, at some point, pay for your college degree.”
Was interest charged on my federal student loans during the pause? Will I have to pay it?
No. According to the U.S. Department of Education, the pause on repayments that began in March 2020 and ended on September 1 was also a pause on interest. That means your loan balance should not have accumulated interest during the last three years – nor should you be charged retroactive interest as your payments come due again.
If you check your account and that doesn’t seem to be the case, contact your student loan servicer or an advocacy group such as the Consumer Financial Protection Bureau.
Why is my loan balance larger than when I graduated even though I’ve been making regular payments?
Because, for many people with student debt, interest has been piling up for years. Nearly half of borrowers are on income-driven repayment plans that peg their monthly payment amount to their income in order to make repayment more manageable. But the reduced monthly payments may be too small to cover the monthly interest on their loans.
The leftover unpaid interest is then added to their loan balance and accumulates interest, which can cause a borrower who is making regular payments to owe even more than their original debt.
A new income-driven repayment plan introduced by the Biden administration last month, the Saving on a Valuable Education (SAVE) plan, addresses this issue by wiping out any monthly interest not covered by a borrower’s monthly payment.
For instance, if a borrower’s $30 monthly payment doesn’t cover all $50 of their monthly interest, the remaining $20 in unpaid interest would be erased. Previously that $20 would pile up and accumulate interest, and cause loan balances to grow even for borrowers making regular payments.
Those with federal undergraduate and graduate subsidized and unsubsidized loans are eligible for the new program and can apply at studentaid.gov.
Borrowers in this situation are also on the agenda of a new federal committee that will begin meeting this month and is expected to propose new rules for the student loan system next year.
STUDENT LOAN SERVICERS
What are loan servicers?
You have likely seen names like Nelnet, Edfinancial or Mohela on your student loan bill. These are student loan servicers, private companies and organizations, that bill and collect the principal and interest from borrowers on behalf of the government. Borrowers owe money to the federal government, not to servicers.
How do they make money?
Contrary to what many people believe, servicers do not keep the interest collected on a loan as their payment. In the past, some servicers received a small percentage of each loan they managed, said Kantrowitz, the college financing expert. But today the federal government pays servicers a flat monthly fee per loan. That fee is typically highest for loans that are in repayment and decreases in amount for delinquent accounts or borrowers in forbearance.
As Kantrowitz explains on his website, the Education Department’s current contracts with servicers incentivize them to help borrowers who have fallen behind on their payments get back on track. But the monthly fee structure also incentivizes servicers to keep borrowers in repayment as long as possible.
TAXES
If my student debt is canceled, do I have to pay federal taxes on it?
No – but only if your loan is canceled this year or in 2024 or 2025. Brunson said congressional legislation passed during the pandemic exempts most student loans canceled between 2021 and 2025 from federal taxation. (Loans made by an employer to cover an employee’s tuition will still be taxed if they are erased.)
But usually canceled student debt is taxed, he said. And unless Congress extends the provision, most borrowers granted loan cancellation after 2025 will have to count forgiven debt as income on their tax returns. That could trigger a big IOU to the IRS.
For example, if a borrower is in the 1% tax bracket, $50,000 of loan cancellation could mean a $5,000 tax bill, Brunson said. A borrower in the 22% tax bracket would owe $10,000.
“Over the course of a person’s life, it’s definitely a better deal, even if you … have to pay taxes on the amount,” he said. “But it is a one-time financial shock.”
Brunson says you can get on a payment plan with the IRS to spread out your tax payments over an extended period of time, but you will have to pay interest.
“So it’s not a perfect solution,” he said.
What about state taxes?
Good news, Illinois borrowers: You won’t be charged state taxes on most student debt canceled between 2023 and 2025. That’s because Illinois defines taxable income the same way as the federal government.
But not all states operate this way.
Brunson said Indiana, for instance, opted to ignore the changes on the federal level. So Indiana residents: If your student debt is canceled, expect a state tax bill.
Lisa Philip covers higher education for WBEZ, in partnership with Open Campus. Follow her on Twitter @WBEZeducation and @LAPhilip.