Over the past decades, the total amount of student loan debt in the United States has more than doubled to over 1.3 trillion dollars (i). Although 67% of borrowers owe less than $25,000 (ii), for many who attend graduate or professional school, balances can grow much larger and payments can make up a large portion of monthly income.
For federal loans, which include loans made directly by the federal government as well as the older FFEL program, the number of options for managing those payments has expanded rapidly over the past few years. Income Contingent Repayment (ICR), the oldest of the plans that tie monthly payments to the borrower’s income, has been around since 1995, but the payments under ICR are fairly expensive and it often did not provide the relief that borrowers needed.
Since 2009, though, the number of options has grown dramatically. In addition to ICR, the new plans include Pay As You Earn (PAYE), Revised Pay As You Earn (REPAYE), and Income Based Repayment (IBR). The last of those, IBR, was modified in 2010 with the new provisions only applying to the most recent of borrowers while the previous rules continue to apply to those who took out loans prior to 2014.
Not only have the number of options expanded, but so has the potential for confusion. It can be overwhelming for a graduate to figure out what options are available let alone which may be best for his or her financial situation.
It is important to note that all of the income driven repayment options discussed here only apply to FEDERAL loans made directly to student borrowers (iii) . The other options are restricted to loans taken out by students for their own education. While technically IBR (Income Based Repayment) is the only program available for FFEL loans, FFEL loans may be consolidated into a direct loan which may then be eligible for PAYE (Pay As You Earn) or REPAYE (Revised Pay As You Earn).Private loans, unfortunately, do not qualify for any of these options and cannot be consolidated into federal loans.
Private lenders often do not offer any flexibility if payments are taking up a large portion of your income and making it hard to balance your budget or achieve long term financial goals. Thus, it is important to be very careful when consolidating federal direct or FFEL loans into a private loan. While the interest rate may be lower, if your income is uncertain or may drop over time, giving up access to income driven repayment options and other favorable provisions that federal loans offer can be very risky!
All three newer programs calculate payments based on the same measure - discretionary income. Discretionary income has a very specific definition here: it is your Adjusted Gross Income minus 150% of the Health & Human Services poverty guideline for your family size. For 2016, the guideline for a single adult is $11,880 in the contiguous US (it is somewhat higher in Alaska and Hawaii) (iv). For example, if you have an income of $50,000 and are single without children, your discretionary income would be $32,180. The income driven repayment calculation would be 10-20% of this $32,180 discretionary income amount.
IBR and PAYE also cap the amount that you can be required to pay if your income rises. This cap is based on the payment you would be making based on your loan balance and interest rate if you were in the standard 10 year repayment plan. These plans also require you to have a “Partial Financial Hardship” to qualify. To be eligible, you would need to have a lower payment under IBR or PAYE than you would make under the 10 year standard plan.
To take a look at how this works, if a borrower has $25,000 outstanding at 5% interest, the monthly payment to pay off the loan in 10 years would be around $265. If your income is high enough that you would pay more than $265 under IBR or PAYE, you do not qualify for those programs. If you qualify, enroll in the program, and your income then rises to the point where your income-based payment is more than $265/month, you would pay $265/month instead.
There are two ways to qualify for loan forgiveness using income driven repayment plan. The first, and most generous, is Public Service Loan Forgiveness. Qualification for this program is based on job type and employer as well as payment plan. In order to apply for loan forgiveness, you must make 120 qualifying payments. A payment is “qualifying” if it is made while enrolled in an income driven plan and while working full time for a government or 501(c)3 organization. This can take as little as ten years, though payments do not need to be consecutive (so those who move from the public sector to the private sector and back again could still be eligible).
Public Service Loan Forgiveness must be applied for after the 120 payments are made and is non-taxable. If you are working towards this type of forgiveness, it is strongly recommended to apply for certification annually to be sure that your payments are counted correctly.
In addition, each of these plans offers a route to loan forgiveness for borrowers who do not make enough to pay off their loans in 20-25 years. This is available to all borrowers repaying through income driven plans, regardless of their type of employment. It is important to note that unlike Public Service Loan Forgiveness, the balance (including any accrued interest) is taxed as income when the loan is forgiven.
Let’s take a closer look at three newest and most affordable plans. While they are similar in many ways, each has a different way of calculating payments, a different number of years before loan forgiveness occurs, and a different way of treating the interest that accrues if your monthly payment does not cover the interest due.
IBR is actually not one but two separate plans. In order to determine which applies to you, look at when your loans were taken out. If you do not remember this, you can get the information online from the National Student Loan Data System at NSLDS.gov. Did you have any outstanding loans on July 1, 2014? If the answer is yes, you are subject to the old IBR rules. If the answer is no, you get the new ones.
For older borrowers, IBR caps payments at 15% of your discretionary income. For our single borrower with $50,000 in income, this calculation leads to monthly payments of around $400/month. If that borrower had $25,000 in loans at 5% interest, he or she would not qualify for IBR since $400 is more than the $265 he or she would owe under the 10 year standard plan. If that borrower had $100,000 in federal loans, however, this would provide tremendous relief from the $1,060 monthly payment under the 10 year plan (v) .
If you are married and file your taxes jointly, IBR uses your joint income. If you file married separately, only your own income is taken into account. While there may be a reduced payment if filing separately, that could increase your taxes. It is best to talk to a tax professional to determine whether the benefit is worth the cost in your situation.
Forgiveness under the old IBR plan occurs after 25 years of payments if you are not eligible for Public Service Loan Forgiveness and have not paid off the loan balance before then.Those who are considering this plan will not be eligible for PAYE or the new IBR provisions.
For those who did not have an outstanding loan balance on July 1, 2014, IBR works a little differently. Instead of being based on 15% of discretionary income, monthly payments are based on 10% of discretionary income. For the $50,000 single earner, this means payments of $268/month. Again this payment would be capped at the 10 year standard payment amount. As with the older IBR plan, income is based on your tax filing status and only includes spousal income if you are filing a joint return.
Forgiveness is a little faster here than with the old rules, for those who do not qualify based on public service employment. Any remaining balance after 20 years (rather than 25) is forgiven.
PAYE has the most complicated eligibility requirements of all of the programs, but is in many ways the most generous option available. In order to qualify for PAYE, you must have:
These restrictions mean that anyone who qualifies for new IBR (no loan balance as of July 1, 2014) should also qualify for PAYE.
As with the newer version of IBR, PAYE calculates payments at 10% of discretionary income and caps them at the 10 year standard repayment amount. As with new IBR, forgiveness occurs after 20 years of repayment, if a balance is still outstanding.
PAYE includes one valuable benefit that is missing in IBR; however, and which can be very beneficial to those with lower income and/or higher balances whose payments are less than the interest the loan accrues (vi) . In that situation, unpaid interest accrues but is not added to the balance of the loan and thus does not generate additional interest. The interest charged each month will be based on the original loan balance as long as the borrower stays in the income driven plan and does not hit the payment cap.
If either of these things happen, the unpaid interest is capitalized, or added to the principal balance, resulting in more interest being charged in the future. Not good! PAYE, however, caps the amount of interest that can be capitalized at 10% of the original principal balance. Especially for someone who is expecting many years of very low income followed by a large income increase (such as a doctor in residency), this could be a very, very valuable benefit.
REPAYE is the newest of the income driven plans. It’s simple to determine who qualifies – everyone with federal direct loans is eligible for REPAYE. REPAYE was intended to offer a number of the features of PAYE without being quite as generous to higher income borrowers, particularly those who have attended graduate or professional school.
Monthly payments are 10% of discretionary income; however, unlike with the other programs, there is no monthly payment cap. Should your income rise, your payments will rise as well and may even be higher than under the 10 year standard plan. For a higher income borrower who can afford large payments and is trying to minimize the total cost of the loan, this may not be a bad thing, but it is risky.
Another way the benefits of the program are capped is through the forgiveness terms. For those who only have undergraduate loans, forgiveness occurs after 20 years of REPAYE payments. For those who have taken out one or more loans for a graduate or professional program, however, that term is extended to 25 years. Again, if you are eligible for Public Service Loan Forgiveness, that would take effect after only 10 years.Lastly, for married borrowers, income is ALWAYS based on combined income no matter how you file your taxes.
There is one significant benefit of REPAYE, however, relative to other programs. As with the other plans, a low income borrower may make payments that are less than the interest being charged on his or her loan. When this happens in REPAYE, though, only one half of the unpaid interest each month accrues. The other half of the unpaid interest is subsidized and will never become due to the borrower. This can reduce the amount subject to tax in the event of loan forgiveness or the amount of interest added to the loan balance if you need to leave the REPAYE plan.
While borrowers can choose one plan and later switch to another, not only will this require more paperwork and time, but it could lead to a capitalization of unpaid interest. Thus when choosing a plan, it is important to take a look at not just your current income, but what you expect your future income trajectory to look like. In addition, if you are expecting forgiveness after 20 or 25 years, make sure you are setting aside money for the tax bill that will be due when your loan is forgiven.
Particularly if you do expect your income to rise in time, it is important to remember that you can always pay MORE than the minimum amount due under an income driven plan. This can be very helpful for those who may have previously had to put a loan in deferment or forbearance and not make any payments during a low- or no-income period. This strategy could also benefit those who have a low income now but expect a significant raise in the future.
The options can be complicated, but these programs do open up a number of opportunities for borrowers who would otherwise fall behind on their payments or else have to sacrifice or defer their other financial goals.
(i) Source: St. Louis Federal Reserve: https://fred.stlouisfed.org/series/SLOAS
(ii) Source: The College Board: https://trends.collegeboard.org/student-aid/figures-tables/distribution-outstanding-education-debt-average-balance-2014
(iii) ICR (Income Contingent Repayment) is the only plan available to Parent PLUS borrowers. For student borrowers, it is more expensive than the newer options and rarely used.
(iv) For more information on HHS poverty guidelines for different regions and family sizes, see here: https://aspe.hhs.gov/poverty-guidelines
(v) For those who do not qualify for a reduction based on their income, it is also possible to lower payments by extending the term of the loan beyond 10 years. For some larger consolidation loans, the default payment would itself be based on a longer term though qualification for income driven repayment is always based on a 10 year term.
(vi) For example, with a $100,000 loan at 5% interest, $417 in interest will accrue each month. If a borrower is only paying $268/month, this will not cover the full interest due and a balance of unpaid interest will begin to build.
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