Income-Based Repayment Plans: Which Is Right for Your Student Loans?

FT Contributor  | 

When you graduate college and get a job, you typically aren’t paid all that much, but you’re expected to start paying off your loans. Without a high income, many people struggle to pay back student loans. Fortunately, there are income-driven repayment (IDR) plans that can lessen your monthly payments based on your income and family size.

Pay As You Earn (PAYE) was the original income-based repayment plan that President Obama announced in 2011. This plan was limited to students who received funds from William D. Ford Direct Loans after October 7, 2007, and students who had funds disbursed to them on or after October 1, 2011. These time-based limitations greatly diminished the number of people who qualified for this repayment plan. In 2015, the Obama administration introduced the Revised Pay As You Earn (REPAYE) plan, which qualified anyone who took out a Direct Loan, regardless of when. Each plan significantly reduced monthly payments, making it easier for low-income earners to pay back their loans.

What Are PAYE and REPAYE and How Do They Work?

PAYE and REPAYE are two government programs that have become increasingly popular with federal student loan borrowers. The idea is that as you enter the workforce, your student loan payments are high but your earnings are low. IDR plans are designed to account for this discrepancy. Below, we break down each type of loan repayment plan and the benefits that come with each.

PAYE

Typically, student loans fall under a 10-year standard repayment plan with payments determined by the balance of the loan. PAYE adjusts monthly payments, making them more feasible for you based on your income. Eligible students can have qualifying federal student loan payments reduced to 10% of what they make each month. This program may cap your loan payments at a smaller percentage of income depending on when your student loans began.

To qualify for the PAYE plan, you must demonstrate financial distress and be unable to make the payments required in a standard 10-year student loan repayment plan. All Stafford, Direct Subsidized, Unsubsidized and PLUS Loans, as well as consolidation loans that do not include loans made to parents, are eligible for this repayment plan. Ineligible loans include uninsured private loans, Parent PLUS Loans, loans that are in default, as well as consolidation loans that repaid Parent PLUS Loans and Perkins Loans.

Monthly payments under PAYE aren’t usually enough to cover the interest that accrues on your loans. Under PAYE, the unpaid interest is only capitalized until the principal increases by 10%. Having a cap on the interest you pay is extremely beneficial and helps prevent you from having to pay interest on interest. As long as you make all of your payments, any remaining balance is forgiven after 20 years.

REPAYE

The REPAYE program eliminates the requirement that you must demonstrate financial distress. No matter what your salary, your payments will never be more than 10% of your income; the size of your family also factors into how much you must pay each month. The biggest contrast between PAYE and REPAYE is that the latter provides an interest subsidy. Because your payments can be so low under REPAYE (sometimes as low as $0), you’re potentially only chipping away at the interest as it accrues on your loans. To combat quickly accruing interest, REPAYE subsidizes the difference between the amount you’ve paid and the amount you still owe for accrued interest at various points throughout the plan.

This subsidy pays the entire payment-interest difference on subsidized loans and half of the difference on unsubsidized loans for the first three years. After that, it covers half of the difference on both loan types.

IBR

Income-based repayment (IBR) is the most widely available and common income-driven repayment program for federal student loans. This repayment method keeps your monthly loan payments reasonable, as they’re based on your individual income. Like PAYE and REPAYE, your payments are based on your discretionary income, as opposed to the balance you owe on the loan. With IBR, your monthly payments may equate to $0, but they still count as an actual payment.

Calculating Monthly Payments With PAYE, REPAYE and IBR

To calculate payments for PAYE, REPAYE, and IBR, start by calculating your discretionary income. Subtract 150% of the poverty level of the state in which you reside from your household income. Your state’s poverty levels are based on household size. Once your discretionary income has been calculated, the percentage of discretionary income that will go toward student loan payments will be 10% to 15%, depending on your payment plan. It’s important to note that discretionary income changes as income changes over time, which means your payments could change over time. This student loan repayment calculator makes it easy to break it down and get a better understanding of your payments.

Pros and Cons of Income-Based Repayment

As with any financial choice, there are pros and cons to choosing an income-based repayment plan. The biggest benefit of an income-based plan is that your payments are based on what you earn. There are several other benefits that come with enrolling in this kind of plan. Here are some of the additional pros of enrolling in a payment plan like PAYE, REPAYE, or IBR:

  • Interest is forgiven; the U.S. Department of Education will pay interest on your loan for up to three consecutive years.
  • Forgiveness at the end of your loan term; after 20 years, borrowers who took loans out after July 1, 2014 — or after 25 years if the loans were taken prior to that date — will be forgiven if you have made payments on time.
  • Loan forgiveness for public servants; if you make 120 payments on time and are employed by a public service organization, your remaining balance will be forgiven.

Income-based repayment plans appear to be all good. However, there are a few drawbacks to enrolling in this kind of loan repayment plan.

  • Your monthly payment is recalculated every year. Changes to your income and family size can alter your monthly payment.
  • Your income must be recertified every year to prevent your plan from being canceled and reverted to a standard repayment plan.
  • Income-based repayment plans focus on lowering what you owe each month, but not how quickly you pay your loans off, which means you’re in debt for a longer period of time.
  • You end up paying more overall because you’re in debt longer, accruing more interest.
  • After 20 to 25 years, your balance may be forgiven, but the IRS views this as taxable income, which means you could be facing an income tax bill of thousands of dollars.

Is Pay As You Earn or an Income-Based Repayment Plan Right for You?

These payment plans can be beneficial but are very borrower-specific when it comes to deciding if they are the right course of action. Generally speaking, if you can’t afford the monthly payments on a standard 10-year repayment plan, an income-based plan may be the right choice for you. PAYE is typically the better choice for married borrowers when both spouses have an income. Conversely, REPAYE is better for single borrowers. If you can afford the monthly payments on your current repayment plan, refinancing and receiving a lower interest rate might be the better route for you.


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