* Student loans payments have been suspended since this blog was written. Please reference this blog for the most up to date information about your student loans!
President Trump announced shocking news that all interest on federal student loans will be waived until further notice. This was just one of many actions that the government and the Federal Reserve are taking to help combat the economic effects of the Coronavirus.
Here are some of the key provisions of the announcement:
- Student loan interest is waived, but student loan principal is still due. This means people will still have to make student loan payments
- Interest will not accrue if you place your loans into deferment or forbearance. This would suspend your entire student loan payment. However, we are still waiting to hear if unpaid interest will “capitalize” into the principal if you go into deferment or forbearance. Update as of 03/20/20, unpaid interest does not capitalize if you instruct the loan servicer to place your loans into “Emergency Forbearance”.
- This applies to federal student loans only. This includes Direct Stafford loans, Direct Grad PLUS loans, Direct Parent PLUS loans and Federally held FFEL loans. Private student loans are not included. Remember , private student loans = less flexibility which is one of the reasons you may not want to refinance your student loans.
You’re probably thinking okay… cool. Well how does that impact me? The answer is… it depends.
Unfortunately, the actual impact is more headline news than actual relief to borrowers. However, there are a few situations to be aware of.
You are currently paying back federal loans on a standard 10-year repayment plan
If you are repaying your student loans on the 10-year repayment plan, then it sounds like your loan payments will actually not change. However, it means that you will pay off your loans faster than originally scheduled if you maintain your payment.
The 10-year standard repayment plan is a relatively simple calculation. You pay the same monthly amount for 10 years and your loan balance will be paid off after the 120th payment.
For example, let’s say Ron Swanson has $150,000 of student loans with an average interest rate of 6%. If Ron selects a standard 10-year repayment plan, his monthly payment will be $1,665/month. The total payments over the 10 years is $1,665 * 120 = $199,800
This means Ron paid $199,800 – $150,000 = $49,800 of interest to the government over that time period. Yeah… they make a fortune from student loans. That’s why Ron hates the government.
So how does interest being temporarily waived affect this?
It means that the 6% interest rate drops to 0% for time being which lowers the amount of interest that Ron pays during the life of the loan. Therefore, the originally planned $49,800 of interest will be reduced (by how much depends on how long the interest waiver applies).
This in turn results in Ron paying off his loans faster than the original 120 payment time period.
You are currently paying back federal loans on an income-based repayment plan
If you are repaying your student loans on one of the income-based repayment plans (PAYE, New IBR, REPAYE, ICR, etc.), then unfortunately, this waiver of interest has no immediate impact on your student loan payment.
Your monthly payments are structured to be about 10% of your monthly income (after a few deductions). The payments have nothing to do with your actual student loan balance. You could have $500,000 of student loans, but if you have no income, then your student loan payment will be $0.
Although there is no immediate impact on your student loan payments, the interest waiver may actually reduce the total amount of interest you pay over the life of your loans.
Let’s use the same example from above– Ron has $150,000 of student loans with a 6% interest rate. Now, let’s assume Ron earns $100,000/year in his role as Parks and Rec department manager. Ron is married to Diane with 2 daughters, so his family size is 4. If Ron selects PAYE, it means his monthly payment would be $506.
However, the first monthly interest charge on his student loan balance is $750. This means that his loan balance would actually grow since the loan balance increases by $750, but he only pays $506. This means his loan balance is now $150,000 + ($750 – $506) = $150,244.
The current interest waiver means that the $750 of interest would be paid by the government, not by Ron. This means that his $506 payment would actually apply to the $150,000 principal directly and thus, lower his total student loan balance. This in turn lowers the amount of interest that he would be paying in the future.
What if you want to postpone your student loan payments?
The Coronavirus has hit many industries hard. In particular, travel, hospitality and restaurants have been hit the hardest. If your financial world has been impacted by the fallout of the Coronavirus, you may find yourself exploring ways to postpone your student loan payments.
There are two options to freeze payments all together –
- Deferment: Typically, when you postpone your loan payments, your subsidized student loans do not accrue interest, but your unsubsidized student loans do accrue interest. Given the current interest waiver, the government would also pay the interest on your unsubsidized loans. This essentially means you are receiving an “interest-free” window where you can prioritize your cash flow somewhere else.
- Forbearance: Forbearance is very similar to deferment, except that typically you owe interest on both your subsidized and unsubsidized loans (as opposed to only the unsubsidized loans for deferment). However, as with deferment, the government would pay the interest on both your subsidized and unsubsidized loans. This again creates an “interest-free” window.
In order to qualify for deferment or forbearance, you need to meet certain criteria. If you speak with your loan servicer and you do in fact qualify, then this could free up a large amount of monthly cash flow that could be used for another purpose.
For example, let’s say as a result of the Parks and Rec department shutting down, Ron lost his job while on the standard 10-year repayment plan that carried a $1,665/month payment. Well, Ron would likely qualify for either deferment or forbearance, which means that he would save $1,665/month and the government would pay all interest that was accruing.
This would allow Ron to build up his cash reserves, pay off credit card debt or do something else with the extra cash.
Now, one of the downfalls of deferment or forbearance is that any unpaid interest is capitalized, which means the interest is added to the principal balance. Unless, the forbearance qualifies for a natural disaster forbearance, which means any unpaid interest is not capitalized. We are still waiting for guidance about this. Update as of 03/20/20, unpaid interest does not capitalize if you instruct the loan servicer to place your loans into “Emergency Forbearance”.
Unpaid interest usually occurs when you are on an income-based repayment plan. If your calculated monthly payment is less than the interest charge, then the unpaid interest grows.
Let’s continue the example of Ron losing his job, but this time, he is on PAYE instead of the 10-year repayment plan. We assume that Ron has been making payments on PAYE for 3 years, but he has accumulated $25,000 of unpaid interest.
This means he has the $150,000 principal balance + $25,000 of unpaid interest. Now, the 6% interest rate is currently only charged on the $150,000, not the $25,000. However, if Ron decided to place his loans in deferment or forbearance, then the $25,000 would be added to the $150,000 and future interest charges would be on $175,000, not $150,000. We are waiting to hear if this $25,000 is in fact added to the $150,000. Update as of 03/20/20, this would not apply!
This is why it’s usually better for someone an income-based repayment plan to recertify their income with the loan servicer if their income has significantly changed since it was last certified. If Ron lost his job, then his income would be $0 and therefore, the calculated student loan payment would be $0. The government would currently pay the unpaid interest on the loans and Ron would still make progress towards taxable loan forgiveness.
Will this effect your path towards Public Service Loan Forgiveness?
Public Service Loan Forgiveness (or PSLF) provides tax-free forgiveness of your remaining federal student loans after making 120 qualifying monthly payments, under a qualifying repayment plan, while working full-time for a qualifying employer.
Due to this strict requirement, 99% of people were denied PSLF. It’s confusing as hell – you need the right type of loans, while on the right type of repayment plan, while working for the right type of employer, with the right type of record keeping.
However, it is possible if you are taking the right steps. If you are on path to PSLF, then this interest waiver honestly won’t impact you. Your overall strategy is to pay as little as possible in student loan payments, so the power of tax-free loan forgiveness is maximized.
This interest waiver may negatively impact your taxes
One of the few benefits of student loans is that you may receive a tax deduction for the interest that you pay on your student loans.
The maximum amount of deduction you can receive is $2,500 which directly offsets your income. For example, Ron’s $100,000 of income would be reduced by $2,500 when calculating his tax due, as long as he paid $2,500 of interest during the year.
However, this $2,500 deduction “phases out” once your income exceeds $70,000 if you file single and $140,000 if you filed married jointly.
If your income exceeds this amount, then the interest waiver has no effect on you since you weren’t receiving the deduction anyway.
However, if your income is lower than this amount, it means that the $2,500 deduction will likely decrease since you currently aren’t paying any interest right now. This is turn may increase the amount of tax you owe in 2021.
Should I consider refinancing my loans?
One of the benefits of economic downturns is low interest rates. There are two catalysts of this – 1) the Federal Reserve reduces short term interest rates and 2) there is a flight to safety which means everybody wants to buy high quality bonds that will pay a “guaranteed” interest rate.
When everybody wants to buy high quality bonds, it allows companies/governments to lower their interest charge because there are so many willing buyers. As a result of the interest rate reduction, private student loan interest rates (along with mortgage rates) have decreased.
In other words, it is cheaper to refinance your loans now than it was 2 months ago. However, if you refinance, you won’t receive the interest waiver that federal loans currently have.
So how do you balance the two options?
You will be better off waiting to refinance if:
- The interest waiver lasts a long time. This will likely be tied to how long it takes for the economy to recover.
- Interest rates continue to decrease which will occur if the economy worsens.
On the other hand, you would be better off refinancing now if:
- The interest waiver is short lived. We quickly get past the Coronavirus and the economy picks up.
- Interest rates go up as the economy rebounds.
If I was forced to bet, I’d say wait. My guess is that this student loan waiver will be around for a while, especially as the economy takes awhile to rebound. Remember, it’s also an election year and Trump will do anything to woo voters…
Either way, beware of the federal loan provisions you lose when you refinance. I beg you to read this blog post about the important features you give up when you refinance to a private bank.
- Overall, this interest waiver doesn’t change much. If you are already on a plan to pay off your loans, it will likely slightly reduce the total amount of interest you pay. If you are on a loan forgiveness plan, it doesn’t change anything.
- The big impact is the interest waiver of deferment and forbearance. This will make it a bit easier for borrowers if they lose their job and need relief on their student loan payments.
- If you are considering refinancing, I recommend waiting a bit to see how this turns out. As long as interest rates don’t rapidly increase (which is possible if the virus passes and the economy quickly recovers), then the current interest waiver may be a stronger benefit over the reduction of interest rate if you refinance.
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