President Joe Biden recently announced a plan that would cancel up to $10,000 in federal student loan debt for borrowers up to certain income limits. The amount forgiven would increase to $20,000 for borrowers who received a federal Pell Grant. The student loan forgiveness plan also extends the pause on federal student loan payments and interest accrual through the end of 2022.
While some of the details have yet to be worked out, student loan forgiveness has wide-reaching implications for millions of Americans who owe money on student loans. Based on research from the College Board, about 45.4 million borrowers held a total of $1.6 trillion in federal student loans as of mid-2021, with an average balance of about $35,000 per borrower. If you happen to be one of those people, now is a good time to take a fresh look at your complete financial picture and take some key steps that might have previously been out of reach.
1. Take an inventory of all your loans, including the principal amount, minimum monthly payment, interest rate, and final payoff date.
If it’s been a while since you looked at any account statements from loan providers or other creditors, it’s helpful to get a handle on exactly what you owe. Gather as much account information as you can from any recent account statements or by logging into the website for each loan provider.
If you have federal student loans, you can also access details about the loans by logging into the U.S. Department of Education’s website. If you have private student loans but have lost track of the details, you may need to reach out to each lender directly to request information or run a credit report by using annualcreditreport.com to see totals for how much student debt you owe.
2. Before making any additional debt payments, make sure you have an emergency fund in place.
If you haven’t already set up an emergency fund, that’s one of the first things to cross off your list. It’s essential to have at least three to six months of living expenses set aside to cover unexpected costs, such as car repairs, medical expenses, or a sudden job loss. These funds should in safe, highly liquid assets that you can easily tap into on short notice if needed, such as a high-yield savings account, money market fund, or ultrashort-term bond fund.
3. Consider paying off other debt with higher interest rates, such as credit cards, personal loans, or car loans.
Start by referring to the inventory I discussed in step 1 above. There are two main strategies to use when approaching debt payoffs. The “snowball” method involves paying off the loan with the smallest balance first (regardless of the interest rate) and then moving on to the loan with the next-smallest balance. This approach can be helpful because it gives you some early wins that can fuel your motivation to keep going, even in the face of daunting amounts of total debt.
The “avalanche” method, on the other hand, involves ranking all of your loans from the highest to the lowest interest rate. You then throw as much extra cash as you can afford at the loan with the highest interest rate while making only minimum payments on the other debts, and then move on to the loan with the next-highest interest rate, and so on. This will minimize the amount you pay in total interest over time and maximize your rate of return from paying off the highest-interest debts first.
4. If you’re currently working, start contributing to your company’s 401(k) plan.
Now that pension plans are increasingly rare, 401(k) plans are the most important retirement vehicle for the majority of workers. A 401(k) gives you control over your own retirement planning; you get to decide how much of each paycheck you set aside for retirement and how to invest your money from a preselected menu of fund options. There are significant tax benefits because 401(k) contributions are made from pre-tax dollars (that is, they reduce your adjusted gross income). That means you can invest more than you would in a taxable account. Contributions also benefit from tax-deferred growth, although you’ll eventually pay income taxes on the money you withdraw during retirement.
Many employers also offer matching contributions. These are typically set up so that your employer chips in additional contributions up to a certain limit; for example, an employer might contribute 50 cents for each dollar you contribute up to 6% of your salary. Matching contributions can be subject to vesting periods, but it usually makes sense to contribute enough to your 401(k) to take full advantage of any company match.
5. Consider contributing to a Roth IRA.
After you've started contributing to your 401(k), consider investing in a Roth IRA. You won’t get an immediate tax break, but you won’t be taxed on withdrawals when you reach retirement age. This can be a significant advantage for younger investors who are currently in a lower tax bracket. Any balances you hold in a 401(k) or traditional IRA will be subject to Required Minimum Distributions when you reach age 72, and those distributions will be taxed at ordinary income rates. Roth IRAs, on the other hand, aren’t subject to any required distributions, and withdrawals are tax-free for investors age 59½ or older who has held the account for at least five years.
You can only contribute to a Roth IRA if your modified adjusted gross income is below certain limits (currently $144,000 for single taxpayers and heads of household, and $214,000 for married taxpayers filing jointly). Contributions are limited to $6,000 per year for most investors.
But even small contributions to a Roth IRA add up over time. If you make a $6,000 one-time contribution at age 25 and are fortunate enough to earn returns averaging 7% over the next 40 years, you could end up with as much as $90,000 by age 65.
6. Make a plan for tackling remaining student loan debt; consider consolidating or refinancing student loans.
Student loan debt is often referred to as “good debt” because it typically carries a lower interest rate than other types of consumer debt, such as credit cards, personal loans, and auto loans. You might also benefit from tax deductions on interest paid on student loans. This benefit is available for all loans used to pay for college or graduate school, not just federal student loans, with a maximum deduction of $2,500 per year.
If your student loans are manageable enough that they don’t interfere with your other financial goals, you may just want to pay them on a regular schedule (final payments are typically due 10 years after the date of issuance, although deferrals are available in some situations). But if student loan debt is weighing down your personal balance sheet, you may want to pay them off more aggressively. There are several excellent calculators you can use to see the costs and benefits of paying down debt.
Some borrowers choose to consolidate their student loans to streamline the payment process. However, this might result in slightly higher interest payments over time.
Finally, you may want to consider refinancing some of your student loans if you took them out during a period when interest rates were higher. (Now that interest rates have headed back up, though, this option probably won’t save you money on loans issued during the past couple of years.)
Conclusion
It’s important to note that student loan forgiveness is politically controversial, so the plan may still run into unexpected roadblocks. And the money to wipe out hundreds of billions in student loans has to come from somewhere, so the effect on the federal deficit (and inflation) won’t be positive. At the moment, though, individuals saddled with student loans have a bit more breathing room.