I’m sure most of us can relate to what it’s like trying to pay off student loans years, and sometimes decades, after taking your last college course. It seems like the monthly payments never go away – and for good reason. The average student loan debt for 2011 graduates topped $25,000, and that number is only expected to grow with the never ending tuition hikes. Nationally, the total amount of student debt has exceeded $1 trillion, more than credit card and auto loans – combined.
If you haven’t opened a newspaper or turned on the news the past few weeks, the interest rates on federally backed Stafford loans is scheduled to double from 3.4% to 6.8% on July 1 unless Congress acts. To make things even more uncertain, 2012 is a presidential election year and there is a large voting bloc of approximately seven million young adults who will be affected by the rate hike. Naturally, each party is trying to gain the upper hand, both legislatively and politically, so this is an issue that likely won’t go away for a while. Politics aside, what is the history and tax implications of the possible rate increase?
In 2007, Congress passed the College Cost Reduction and Access Act which gradually reduced the rate on subsidized Stafford loans from 6.8% to 3.4%. Like all good bills Congress passes to lower the financial burden on its citizens (usually in the form of tax cuts, but in this case an interest rate reduction), it is set to expire. The rate increase will only affect subsidized Stafford loans issued after July 1. Loans issued prior to July 1 will not be affected since the rates are fixed over the life of the loan.
With the rate doubling from 3.4% to 6.8%, a borrower with a $10,000 loan will pay an extra $2,000 in interest, or $16.66 each month, based on a 10 year repayment term before any tax benefits.
Taxpayers can take an above the line deduction for student loan interest up to $2,500. To qualify, the loan must be a qualified student loan, the interest must be paid in the year the deduction is claimed, your filing status is any status except married filing separately, and your modified AGI is less than $75,000 if single, head of household, or qualified widow(er), or $150,000 if married filing jointly. Phase out of the deduction begins at $60,000 and $120,000 of modified AGI, respectively.
Using the above $10,000, 10 year repayment example, an individual filing single with a modified AGI of $60,000 will save $625 in taxes, or 25% for every dollar of student loan interest. Therefore, the true cost of the rate increase is only $1,375 over the life of the loan. Of course, there are a host of factors ranging from the amount and type of income, deductions and exemptions claimed, filing status, loss carryovers, and marginal rate that will affect each person’s tax return differently, so the true tax savings will vary.
Depending on what Congress decides to do, there may not even be a rate increase that students need to worry about. That is until the extension of the rate reduction is set to expire and we get to go through this all over again!