Wiping out the nation’s student-loan debt could have unintended financial consequences for borrowers

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Democratic presidential candidate Senator Bernie Sanders won New Hampshire’s Democratic primary Tuesday, narrowly beating more moderate candidates and easily topping another progressive in the race, Senator Elizabeth Warren.

The Senator from Vermont’s win keeps his sweeping policies in hard focus, which range from “Medicare for All” to higher taxes for the super-rich to student loan debt cancellation.

Sanders and Warren are both proposing free public college and student loan debt cancellation on a grand scale. In fact, Sanders wants to cancel all student loan debts while Warren caps eligibility depending on income. The Massachusetts senator placed fourth in New Hampshire.

New Hampshire voters in at least one Tuesday exit poll said health care was the most important issue for them, while CNN said two-thirds of polled voters supported free tuition at public colleges.

Sanders and Warren have said their student-debt cancellation plans will help young Americans and their families finally get a fresh start after being buried in debt for so long.

Research has suggested that cancelled debts can be a major boost for borrowers and the economy overall. When 10,000 borrowers had their private student loans canceled, their income increased on average by $4,000 over three years, a 2019 working paper found.

Debt cancellation also gave them a better shot at moving or starting new jobs, that same study discovered. Another 2018 estimate said debt cancellation would inject an average of $108 billion into the economy every year for 10 years after the mass cancellation.

But wiping out up to $1.6 trillion in student debt could have other financial repercussions for individual borrowers, experts say.

Among them: Some borrowers could see their credit scores go down temporarily and their tax bills go up the year the debt is canceled. That’s because credit bureaus may have one less payment source to evaluate a borrower’s creditworthiness.

Current Internal Revenue Service rules say when a borrower’s student loans are canceled, the amount of the loan can be added to their taxable income, but there are exceptions to those rules.

The IRS recently said that some borrowers who had their loans canceled because they attended certain schools that defrauded them don’t have to report the amount of their cancelled loan on their income return.

But the IRS and Treasury Department have not issued guidelines on what would happen if all student loans were wiped away through the Department of Education on the instructions of the president. The Department of Education and Treasury Department did not respond to request for comment from MarketWatch. An IRS spokesman said it would be inappropriate for him to comment on the legislative proposals from Sanders and Warren.

Both the Warren and Sanders campaigns say they will work to ensure that debt cancellation doesn’t result in larger tax obligations for borrowers. The student-debt cancellation legislation that Sanders co-authored includes a provision stipulating that the amount of a borrower’s eligible federal student loans forgiven by the bill would not be included in their gross income for tax purposes.

The Sanders plan would wipe away all student debt and have no income caps. His plan includes private student-loan debt.

Comparatively, Warren has said she will cancel $640 billion in federal student-loan debt overall if she is elected. Borrowers making up to $100,000 a year would be eligible to have $50,000 in debt wiped away. People making between $150,000 and $250,000 a year would be eligible only for partial debt relief.

Here are some of the ways student-loan forgiveness could affect borrowers’ finances:

Student-debt cancellation would raise tax bills under existing rules

A cancelled loan means people no longer have to pay a lender, but current IRS rules say borrowers — with certain exceptions for scammed students, permanently disabled veterans and public-sector workers — still have to pay the tax authority before they can get out from under a student loan.

Take a hypothetical borrower who owes almost $18,000. (That’s the median student-loan balance for all borrowers, according to the Federal Reserve Bank of New York.) Suppose that same borrower made $63,179 a year, which the U.S. Census said was the 2018 median household income.

If the loan was canceled, the IRS — under current rules — would count that $18,000 as income, bringing the borrower’s total taxable income to $81,000 a year. (Both Warren and Sanders have said they would work to change these rules to ensure that borrowers wouldn’t see their tax bills go up.)

Read more: Where the 2020 candidates stand on student debt and college affordability

Depending on what other money the person earned that year, the canceled loan amount could bump them into a higher tax bracket and trigger a bigger tax bill, said Barbara Weltman, an attorney and author of “J.K. Lasser’s Your Income Tax 2020.”

If that hypothetical single person earned just $2,201 more, they would be pushed from the 22% income-tax bracket into the 24% tax bracket. What’s more, a hypothetical married couple that makes a median income and has the median student-loan balance would potentially jump from a 12% federal tax rate to a 22% federal tax rate.

Like forgiven loans, the same current rules apply to lottery winnings, unemployment benefits, interest on checking and savings accounts, and even certain types of legal settlements, Weltman said.

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Getting taxed under a higher tax bracket could also make someone ineligible for certain tax breaks, Weltman added, including the earned income tax credit — which supplements the income of working lower-income taxpayers — and the IRA deduction for those taxpayers who also contribute to a retirement plan at work.

A married couple filing jointly with three kids can’t have more than $56,844 in adjusted annual gross income to claim the earned income tax credit. People who have more than $104,000 a year in modified adjusted gross income can’t get the full IRA contribution deduction.

“There are all sorts of ramifications,” Weltman said. Congress would have to pass laws amending the tax code before borrowers could avoid reporting the canceled debt as income, she added. “The IRS does not have authority to say ‘Poof, it’s gone.’”

A. Wayne Johnson, a Republican former U.S. Education Department official who is running for U.S. Senator in Georgia, and is also calling for the cancellation of $925 billion in student debt, said Warren and Sanders would have to get any tax law changes through Congress — and persuade Republicans — to change rules for borrowers.

They could not, he said, do it by executive action.

Even if federal laws are amended, state tax authorities might still consider the forgiven loans as taxable income, Johnson said. For his own cancellation efforts, he said he would “aggressively talk to the states … to try and have them see the wisdom of not charging tax consequences.”

Even if tax law did not change and student debt was wiped out, Robert Kelchen, a Seton Hall University professor focused on the finance of higher education, said any tax headaches are “still a small price to pay” compared to finally be free of student debt.

“You’re effectively settling your student-loan debt, paying pennies on the dollar,” he said.

Kelchen supports limited loan cancellation, but has misgivings about wholesale cancellation. Complete debt cancellation could be a “windfall to many wealthy borrowers,” Kelchen said. The taxpayer, rich or poor, would effectively pick up the bill.

He has big questions on whether well-off students should benefit from cancellation, but also logistical ones, like whether the IRS has the capacity to handle an influx of borrowers who suddenly have no student-loan debts, but a large tax bill waiting for them.

Many of those borrowers may have to pay their tax bills in installments, which could create additional administrative burdens for the IRS, he said.

Borrowers with higher debt balances tended to have graduate degrees. Loan debt is “still a burden” for these borrowers, but Kelchen said “they are better off than many Americans.” Kelchen said Warren’s $100,000 annual income cap for full debt relief of up to $50,000 takes that into account.

Also see: Resigning Trump administration official says student-loan system is ‘fundamentally broken’ — here are some possible solutions

“It’s an issue of who’s ultimately paying for this and how much the federal government and federal taxpayers are willing to spend?” he said.

Instead of applying loan relief to wealthier students, Kelchen said that money could increase funding for Pell grants, which are needs-based grants for low-income student that do not need to be repaid. He said the money could also be used to defray housing costs and child-care costs for students with children. (Student parents comprise approximately 20% of all college students.)

Borrowers could see their credit scores drop if their student loans are cancelled

As one of the first loans many people take out, student loans are very influential in building people’s credit scores and profiles. Student loans influence a person’s credit score in myriad ways. For instance, making on-time payments toward student debt is viewed favorably by credit bureaus, said Ethan Dornhelm, vice president of scores and predictive analytics at FICO

Getting rid of debt is usually viewed favorably in constructing credit reports and FICO scores. But there are a number of ways that removing a debt obligation can hurt a person’s credit score. “The impact will depend on the specifics of a given consumer’s student loans as well as their overall credit profile,” Dornhelm added.

The age of the oldest credit line is another major factor in calculating a credit score and, for many borrowers, their first loan is their student loan. No longer having a student loan would reduce their “credit mix,” which could also be viewed unfavorably for credit-scoring purposes.

Having a lower credit score can have significant consequences on people’s financial lives. It can change what types of loans and credit cards a person can qualify for. It also typically leads to a borrower having a higher interest rate.

A recent study from Lendingtree found that the average American with a “fair” credit score (in the range between 580 and 669) pays up to $41,416 more in interest over the life of a mortgage loan versus someone with a “very good” score (between 740 and 799).

Read more: One argument for canceling student debt: Student-loan borrowers may be far poorer than most economists believe

In some circumstances, student-loan borrowers could suddenly find themselves “unscorable” if their student debt is erased, said Francis Creighton, president and CEO of the Consumer Data Industry Association, a trade group that represents the major credit-reporting agencies Experian , Equifax  and TransUnion, among other companies. That would happen if someone’s only form of debt was their student loan.

Already millions of Americans are considered “credit invisible,” meaning they don’t have any or enough credit history with one of the three major credit-reporting companies to get a score. A 2015 report from the Consumer Financial Protection Bureau estimated that some 26 million Americans were in this camp.

People who are “credit invisible” often have a more difficult time getting loans such as mortgages because it is more difficult for lenders to assess their ability to repay without their credit history.

“If you don’t have a score, a lot of lenders will not consider you at all,” said Tendayi Kapfidze, chief economist at LendingTree . People in this circumstance would need to turn to other methods to build up their credit, such as opening up a secured credit card or adding their bank-account information to their credit profile through Experian Boost, Kapfidze added.

The credit-reporting agencies have not yet investigated possible changes to their scoring procedures in the context of student-debt cancellation, Creighton said. (When asked for comment on student-debt cancellation, Experian, Equifax and TransUnion referred MarketWatch to the Consumer Data Industry Association.)

Warren historically has supported changes to credit scoring and is open to addressing situations where debt cancellation may negatively affect credit scores, a campaign spokeswoman told MarketWatch.

Similarly, a spokesman for the Sanders campaign said that a Sanders administration would work to ensure that credit reports and scores were not negatively impacted by the cancellation of their student debt. Sanders has also called for replacing the private credit-reporting agencies with a public credit registry in order to “remove the profit motive from assessing the creditworthiness of American consumers.”

Borrowers who defaulted on their student debt would get a credit-score boost

Of course, those who were delinquent or missing payments on their student loans would see their credit scores rise if their student debt were forgiven, Creighton said.

A September 2019 report from the U.S. Department of Education noted that 10.1% of borrowers who entered repayment on federal student loans between Oct. 1, 2015 and Sept. 30, 2016 defaulted. A separate study from the Urban Institute, a progressive think-tank in Washington, D.C., estimated that 250,000 federal direct student-loan borrowers default for the first time every quarter.

Having such a loan removed from their credit profile would almost certainly cause their score to increase. It is not clear, however, whether the borrower’s history of defaulting on the loan prior to its cancellation would remain on their profile.

Whatever the impact, credit scores are designed to change over time, so the effect would likely diminish in the years following the cancellation.

“More recent information is more relevant than older information,” Creighton said. “Let’s say you do something and it impacts your score by 100 points right away, after a year it might only impact your score by 50 points.”

Long-term benefits could outweigh short-term costs

Most experts said the benefits of having a student loan wiped out outweighed any short-term financial consequences. The study of 10,000 borrowers whose incomes went up after their loans were canceled also showed that their credit scores increased after the debt was wiped away.

This largely occurred because the borrowers studied were in default on their private student loans before they were forgiven as the result of a clerical error, said Marco Di Maggio, one of the study’s co-authors and a professor at Harvard Business School.

“Overall, we find a significant improvement of the borrowers’ financial condition after the forgiveness, as they are able to reduce their indebtedness, are less likely to default on other loans, and find better jobs,” Di Maggio said. “Accepting or rejecting these proposals based on just the potential changes on credit score misses the big picture, as it assumes that the borrowers without the burden of the student debt would behave in the same way, which is not reasonable.”

Also read: This government loan forgiveness program has rejected 99% of borrowers so far

A group of Brandeis University researchers who support Warren’s proposal have said that “the greater ability to save and build assets entailed by a lower debt load would generate additional wealth and would be significant in the lives of debtors,” including by increasing credit scores.

As cancelling debt frees up income, that money can go toward other debt obligations. Any possibility of lower credit scores is “a nominal cost to pay,” said Cody Hounanian, program director of Student Debt Crisis, an advocacy group for borrowers that supports some form of debt cancellation but has not endorsed any particular plan.

“For borrowers that are maybe going to pay more on other bills because their credit score hasn’t been improved by repayment, shedding the student-debt burden will create many more financially positive opportunities for them,” he said.

This story was updated on February 12, 2020.

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