Divorce is stressful and complicated and hurts on so many emotional and financial levels. It becomes even more complex when you throw in the additional financial stress of student loans. It can be hard to deal with even after you have decided that a student loan is a marital or separate debt.Student loans are a complex liability because there are so many different and complex methods for repayment. They come with many acronyms such as PAYE, REPAYE, IDR, and PSLF.
The borrower’s circumstances can also play a huge factor in deciding how to deal with student loans properly. For example, you might not have to repay your student loans in total if you get student loan forgiveness for various reasons. The most common are taxable long-term forgiveness or Public Service Loan Forgiveness.How student loans are handled in a divorce is not altogether easy to understand. Depending on the laws of the State in which the divorce occurs, if one of the parties incurred student debt before the marriage, it could be considered separate property. It is especially common if the borrower’s partner received no economic benefit from the student loans or if the parties come from certain states that have community property laws (1).
But what happens if you have Parent PLUS loans that you took out for your children? Let’s imagine a case in which a couple has been married for years, and one spouse has taken out $250,000 of Parent PLUS loans under her name to pay for their two children’s college education.
Unfortunately, this is a common situation. Arguably, because the Parent PLUS loans were taken out during the marriage for the benefit of their children, they ought to be considered marital debt (1).
Let’s take a closer look at the case of Jack and Jill. They are both 55. Jack makes $180,000 a year working for an accounting firm, and Jill makes $45,000 working for a 501(c)(3) non-profit organization.
Jill has $250,000 of federal Parent PLUS loans that charge a 6% interest rate. As a result, Jack and Jill expect to pay $2,776 a month or $33,312 a year. Even with a joint income approaching $200,000, it is a significant financial burden that impairs their ability to plan for retirement and other long-term goals.
If Jack and Jill refinance at 3%, it will reduce the monthly payments to $2,414 a month. Although the $362 monthly savings are welcome, they are not a significant improvement in their situation.
Divorce has a way of making money scarce and future projections challenging. In many divorces, the division of assets and debts approaches 50%, meaning that the burden of paying for her half of the loans would be significantly greater on Jill, who only makes $45,000 a year. Even with an asymmetric division to reduce Jill’s share, it will likely not be easy to sustain (2).
Jack and Jill have agreed to sell the family home as part of the divorce. They expected to net about $250,000 after expenses and mortgage repayment to be divided equally. Jack wants to use the proceeds from the sale to pay off the entire parent loan balance. Jack had heard horror stories about other parents not being able to retire because of parent loan payments, so he wanted to get rid of the balance and not worry about monthly payments that could continue into his retirement.
So, he and Jill decide to split the loans down the middle. It means that Jack will pay Jill $125,000 from the sale of their shared home since the Parent PLUS loans are in Jill’s name. With that, Jack’s share of the parent loan debt is addressed, and he believes that Jill should use her share of the sale to pay her half of the debt.
Here’s the thing. With the $125,000 that she would receive from Jack and her $125,000 share from the home sale, she could pay off the debt and move on to other issues. Jill was all in on the idea of each side paying half of the loans until she spoke to a Student Loan Strategist and decided to take a different route with the $250,000 of Parent PLUS loans still in her name.
Jill has always been passionate about providing support for vulnerable children worldwide. She works full-time at a local charity, a 501(c)(3) non-profit organization, making $45,000 a year. She loves her work and has no plans to retire for at least ten years. In this case, Jill could qualify for Public Service Loan Forgiveness (PSLF). It means that she could get her loans forgiven tax-free after she makes 120 monthly payments in an Income-Driven Repayment plan (2).
Here is a summary of Jill’s parent loan repayment options:
Let’s take a look at each option in detail.
In this case, the total cost of the parent loan is $250,000. This way, Jill can get rid of the parent loans in her name. However, Jill still needs to figure out her post-divorce life, including how to pay for her new housing and how to invest the other assets she may receive from Jack from the asset division from their divorce.
The cost of paying off $250,000 of federal loans with 6% under the default 10-year Standard repayment plan is $2,776/mon and $333,061 total over the ten years. However, if Jill could find a private refinancing deal at 3% interest for the same 10-year term, the cost is $2,414/mon and $289,682 total, which is $362/mon and $43,379 savings in total. It may make sense for Jill to do that if she needed to use the $250,000 home sale proceeds to buy a new house to live in, and she could afford the $2,000+ per month of payments for the student loans. However, this is not an attractive option for Jill since her monthly income is $3,750, and the loan payments would absorb so much of it. Even if her divorce agreement provided for alimony, it would still be difficult.
Typically, federal Parent PLUS loans are only eligible for one of the Income-Driven Repayment plans called the Income-Contingent Repayment (ICR) plan even after being consolidated into a Direct Consolidation Loan.
Still, in some cases, they can be “double consolidated” (read more about this loophole strategy here) and qualify for cheaper Income-Driven Repayment plans. For example, let’s say that Jill double consolidated her parent loans, enrolled in Pay As You Earn (PAYE), and pursued Public Service Loan Forgiveness for ten years. Then, filing taxes as Single every one of those years, working for the 501(c)(3) employer and making the same level of annual income ($45,000 adjusted annually for inflation), she pays $205 to $283 monthly and a total of $29,059 over ten years.
The remaining loan balance (which happens to be $430,633 under this scenario) is forgiven tax-free under current tax rules. In this case, assuming that Jill makes the $205~$283 monthly payments out of her cash flow, she gets to keep all $250,000 from the home sale proceeds and pay off the parent loans for just under $30,000. She can use the $250,000 to buy a new home for herself or invest it in retirement, whatever she and her wealth strategist thought would work best (3).
Did we mention that student loan repayment options can be complicated? Jill should ensure that she has her ducks perfectly aligned before engaging in the double consolidation/PSLF strategy. In the worst case, she could have missed something and may remain liable for the entire loan and the full payment or end up with a very large tax bill. Hence Jill should get an experienced student loan strategist to counsel her on her strategy.
If she felt inclined, she could discuss this PSLF option prior to the divorce with Jack and divide the benefit between them. However, Jill should remember that the burden is still on her because under this strategy, she has to stay in the PSLF program for ten years. That obligation is not quantified but should be considered in the asset division.
Sometimes we can find a silver lining in the worst situations. In their divorce, Jack and Jill could take advantage of a quirk of student loans and could save up to hundreds of thousands of dollars. As a result, Jill could have an additional $220,234 to support her lifestyle.
Student loan repayment strategies can be very different depending on the situation. For example, it would be an entirely different situation if Jill’s income was higher, her employment did not qualify her for PSLF, or she retired earlier than expected. There are still pitfalls ahead for her.Solutions to student loan problems tend to be very unique and difficult to generalize. If you have federal student loans, the short and long-term costs can significantly differ depending on your income situation and the repayment plan you choose. However, as a federal student loan borrower, remember that you do not always have to pay back the entire loan balance.
Everyone’s situation is different, especially in divorce, especially with student loans. If you are unsure what to do, reach out for help. It might pay off!