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What if your student loans could just… go away?

For years, student loan cancellation seemed like a progressive pipe dream. But now it is gaining real momentum and mainstream support. President Joe Biden’s office said he would ask Congress to cancel $10,000 in student debt for all borrowers.

But Democratic lawmakers and progressive groups have pressed the president to bypass a deeply divided Congress in favor of executive action. According to many, the president has the authority by executive order to directly cancel federal loans issued through the Department of Education.

Not only that, but a more generous resolution sponsored by Senate Majority Leader Chuck Schumer (D-N.Y.) and Sen. Elizabeth Warren (D-Mass.) calls for canceling up to $50,000 in student loans rather than $10,000.

Biden has since gone on record to say that he would not do so through executive action, but he has not ruled out supporting $50,000 in student loan cancellation if Congress took action.

According to Warren et al., canceling up to $50,000 in student loans should be a high priority because it would deliver real relief to debt-burdened households, lift up our struggling economy, and close the racial wealth gap during a period of “historic and overlapping crises” that have disproportionately affected communities of color.

Could forgiving student loans really do that much good? And who would benefit most? Let us take a closer look at the numbers to determine the impact of canceling student loans at different levels on both individual households and the larger economy.

1. Could Loan Cancellation Help Narrow the Racial Wealth Gap?
According to data from the Survey of Consumer Finances, nearly one third of households have student loan debt.

When you take a look at the demographic details of who holds that debt, some clear patterns emerge. One is that Black/African-American households hold much more student debt than borrowers of other races.

The graph below shows how many households in different racial groups have student debt (in any amount) and how the numbers would change with loan forgiveness in the amount of $10,000 and $50,000.

It is clear that fewer people would owe money after loan forgiveness, but would the policy really help level economic inequality among races? Possibly. The New York Times cited an analysis by the Roosevelt Institute that indicated the total percentage of Black households that would benefit would be greater than white households. Not only that, the researchers found that the relative gains for those households’ net worth are far larger.

But would the policy really deliver relief to the borrowers that need it most? Sort of. We looked at the breakdown of households with student loan debt by income quartile now, as well as these breakdowns after $10,000 and $50,000 of loan forgiveness.

Looking at the changes in the lowest and highest income quartiles, $10,000 forgiveness removes student debt for 34% of households in the lowest quartile and 29% of households in the highest quartile.

Forgiving $50,000 eliminates debt for 85% of households in the lowest quartile and 70% of households in the highest quartile.

In actuality, a large percentage of the money would go to households with higher incomes, because a higher percentage of these households have student loan debt to begin with. But the forgiveness programs will also direct a significant amount of money to more lower-income families to help them overcome their debt burdens.

2. Could Loan Cancellation Help Boost Retirement Savings?
This may seem obvious to say, but canceling debt frees up money in people’s budgets that they can spend in other ways. One of the things people can do with this money is invest it for retirement.

An analysis by Brandeis University also mentions saving and investing as a benefit of student loan cancelation: “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.”

And according to SCF data, only half of all U.S. households has any money saved for retirement at all.

An obvious counterpoint is that we do not actually know what people will do with the extra money in their budgets from the canceled loans. Maybe they will save it, maybe they will not. The other argument is that the extra money is already there: Remember that President Biden already extended the suspension on loan payments and interest on all federal student loans through September 2021.

3. Could Loan Cancellation Benefit the Economy?
It may be optimistic to assume that canceling student loan debt will be the solution to closing the retirement savings gap in this country. Surely, not everyone will prudently invest this extra cash flow in a retirement savings account. They will just spend more.

But guess what? Consumer spending is 70% of our economy. So money that is spent is actually far more “stimulating” to the economy than money saved.

Increased consumer spending could stimulate the economy in a number of ways. Calling it a “no-brainer for our economy,” Warren points out that loan cancellation will also help individual borrowers because it could lead to improved credit scores, which in turn allows borrowers to qualify for cheaper loans. Being able to borrow money on more favorable terms leads to greater home-buying rates and housing stability, higher college completion rates, and greater business formation, Warren said.

Opponents of the idea argue that loan forgiveness is very expensive and not a particularly effective way to stimulate the economy—at least in the short term—because it does not free up as much available cash as it would seem. Instead of giving the average household $10,000 or $50,000 to spend, it would relieve them of their monthly interest and principal payments, which normally total $200-$300 per month for the typical borrower in repayment.

And, as mentioned earlier, thanks to the extension on student loan payment relief, that money is already in people’s budgets until at least September 2021.

4. Would You Have to Pay Taxes on the Amount of Debt Canceled?
Maybe. According to the IRS, in most cases where a lender cancels or forgives your debt for less than the amount you must pay, the amount of the canceled debt is taxable and you must report the canceled debt on your tax return for the year the cancellation occurs.

The IRS adds that the canceled debt may not be taxable, however, if it can be legally excluded from gross income. (As part of their proposal, Schumer and Warren have asked that the IRS waive the tax obligation for the forgiven loans, through Internal Revenue Code of 1986, which would prevent administrative debt cancellation from resulting in a tax liability for borrowers.)

5. What Are Some Alternatives to Loan Cancellation for Low-Income Students?
Not everyone agrees that eliminating student debt up to a certain cap—$10,000 or $50,000—provides meaningful relief to those who need it most. A study by a Wharton finance professor and a professor from the University of Chicago’s Booth School of Business suggests that directly canceling student loans would actually increase economic inequality because most of the benefits will accrue to upper-income borrowers.

They argue that for low-income earners, balance forgiveness (and particularly partial forgiveness up to a cap) erases debt that was already scheduled for cancellation under existing income-driven repayment rules. For high-income earners, however, it is a real gift.

An alternative to student loan forgiveness that would benefit more lower- and middle-class borrowers would be an extension of the government’s income-driven repayment program, they posit.

Another criticism of student loan cancellation is that it picks winners and losers: In other words, it does nothing to eliminate the debt burdens of past and future borrowers.

Researchers at the University of California argue that doubling the amount of the Pell Grant, from $6,345 to $13,000, would be a more equitable way the government could help low-income students afford college with no obligation to repay debt.

In the end, it is a policy choice that comes down to values, said Morningstar’s head of policy research Aron Szapiro:

“Some people feel that it is fundamentally unfair to pay off debt for some while doing little for those that avoided it or did not have the benefit of a college education. Others see a moral issue with letting millions of mostly young people struggle to pay for an education that is a prerequisite for many careers and opportunities.”

 

© Morningstar 2021. All Rights Reserved. Used with permission.