How Not to Squander Student Debt Forgiveness
If this windfall becomes reality, you need a plan
Millions of American households may soon be on the receiving end of a hefty windfall if the incoming Biden administration pursues cancelling federal student loan debt.
As of early December it wasn’t yet known if loan forgiveness is in the mix of new initiatives, nor the scope of any such relief. But it is definitely swirling around as a distinct possibility. And that makes right now the perfect time to hatch a plan so you maximize the benefit of any cancelled debt.
Whether your monthly payment is $200 or $800, without a detailed plan, you don’t want to end up wasting the windfall, any more than you would an inheritance or bonus from your work.
You may owe taxes.
The federal tax code typically views forgiven debt as a form of taxable income. The thinking is that you have received a financial benefit, and the IRS wants its slice of that pie. Legislators could make the forgiveness tax-free, but there’s no guarantee of that
Perhaps when you were young, your parents employed the popular three-bucket approach to teaching you about money that required you to earmark some for spending on whatever, some for saving and some for charity. That approach ages well.
Of course, using 100% of your student debt forgiveness to get after financial goals such as building an emergency fund or saving for a home down payment is great. But it’s more than OK to carve out a small percentage for spending. On whatever. Similar to a diet cheat day. Earmarking some for charity needs no further explanation, right?
Prioritize based on anxiety.
Self-quiz time. What are the financial issues that nag at you most? Or flip the exercise to feel-good: What are the financial goals that would make you feel so much better if you were able to make progress on them?
Some unsubtle hints:
Build an emergency fund to cover living expenses for at least a few months.
Pay off high-rate credit card debt.
Save (more) for retirement. The younger you are, the more important it is to set aside money for retirement now. Every month you delay reduces the explosive upside of compound growth.
If you no longer have a $300 monthly student loan payment, you might use $100 to accelerate wiping out high rate debt, $100 for your emergency stash and add $100 to your retirement savings. Up to you how you divvy it up.
About credit card debt.
In purely financial terms, the smartest move is to first focus on paying down the card with the highest interest rate. That “saves” you the most. But for some people it’s more empowering to focus on the card with the smallest balance, and get that paid off ASAP.
The right move is the one that sparks the most joy. It’s likely to take you many months (maybe a few years) to dig out of credit card debt, so it’s important to commit to a plan that keeps your financial-goal endorphins flowing.
On cars, less is more. If you’re already scheming to use your newfound monthly cash to buy a car, the decision you make now will play out for decades. Don’t lease, and don’t buy a new tricked-out car that qualifies as an indulgent want. Both are financial sinkholes. If you need a car, the focus should be on a used car that you finance with a shorter term (48 months max) loan. The payoff in retirement can be having an additional $100,000+ stuffed in your IRA or 401(k).