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How Student Loans Work

Student Loan Forgiveness

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Student loan forgiveness is available in some circumstances, but students have to meet strict qualifications. Klaus Vedfelt/Getty Images

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You may be wondering what happens to the remaining balance at the end of your 20- or 25-year payment term. Does income-driven student loan repayment work like a balloon mortgage, requiring that the balance be paid in full at the end of the loan term? Thankfully not. According to Federal Student Aid, "Under all four plans, any remaining loan balance is forgiven if your federal student loans aren't fully repaid at the end of the repayment period."

Another program might help you reach the loan forgiveness grail even faster. The Public Service Loan Forgiveness (PSLF) plan forgives the remaining balance on direct loans after just 120 qualifying monthly payments (or 10 years) that you made under a qualifying repayment plan if you're working full time for a qualifying employer. To be eligible, you need to work for a government or nonprofit organization. AmeriCorps and Peace Corps count here too, but labor unions, partisan political organizations and for-profit organizations do not, even if they have government contracts.

But PSLF has been getting some bad press since the first wave of possible loan forgiveness borrowers have reached their 10-year term. Forbes contributor Preston Cooper reported that 99 percent of loan-relief applications were rejected. However, the majority of them had not made the required 120 minimum payments, while others were missing information from their application, did not have eligible loans or did not work for a qualifying employer. Be sure to check the requirements carefully if you are seeking this type of loan forgiveness.

Whether taking 10, 20 or 25 years, income-driven repayment ending in student loan forgiveness sounds pretty amazing for the borrower, especially one with a significant amount of student loan debt who had been thinking the loans would surely die with them.

However, borrowers should be aware that student loan forgiveness may have an unwelcome effect on their tax return. Referred to as a "tax bomb," it comes from the requirement that the forgiven amount is supposed to be reported on your tax return as income, although there may be exceptions. In an article for Student Loan Planner, Stephen Mercer explained that the hit could be as much as 37 percent of the amount forgiven depending on your taxable income. The tax bomb applies only to the 20- to 25-year income-driven repayment plans. With PSLF forgiveness, your balance is not considered taxable income.

Travis Hornsby, founder of Student Loan Planner, told us he isn't so sure the tax bomb will become reality, questioning whether the government will really try to collect on someone who paid on-time student loan payments for up to 25 years. Of course, it's too soon to tell, and there is no guarantee. "It's 'reading the tea leaves'," he says. In anticipation of the possibility, he suggests putting some money in an investment account just in case you need it down the road for the tax hit.

But even with all of these repayment options, some borrowers simply find that they don't have the cash they thought they would after graduation. Read about what it means to default on student loans on the next page.

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