Income-driven repayment plans are complicated, with lots of details. No wonder that borrowers may make mistakes when choosing and using an income-driven repayment plan.
Complexity of Income-Driven Repayment
There are many details that affect the cost of an income-driven repayment plan. These details may differ among the four income-driven repayment plans, making it challenging for borrowers to choose among the income-driven repayment plans.
The most important details affecting the cost of an income-driven repayment plan include:
- Percentage of Discretionary Income (10%, 15% or 20%)
- Definition of Discretionary Income (AGI – 150% or 100% of the Poverty Line)
- Repayment Term (20 years or 25 years)
- Tax Status of Loan Forgiveness at End of Repayment Term (Taxable, Tax-Free)
- Public Service Loan Forgiveness (10 year repayment term, tax-free)
- Payment Cap (Monthly loan payment capped at the Standard Repayment amount or not)
- Marriage Penalty (Married borrower’s income based on joint or separate income)
There are also secondary details that can affect the cost:
- Minimum Payment (Rounded up to down at $0, $5 or $10)
- Capitalization of Accrued but Unpaid Interest (Frequency, 10% Cap)
- Payment of Accrued but Unpaid Interest (Subsidized vs. Unsubsidized Loans, During and After First Three Years)
- Education Level (Borrowed for undergraduate or graduate education)
There are also details that affect a borrower’s eligibility for each income-driven repayment plan:
- Type of Federal Loans (FFELP vs. Direct Loans)
- New Borrower Status Date
- Date Loans Disbursed
Error: Choosing the Wrong Income-Driven Repayment Plan
The complexity of the income-driven repayment plans can cause borrowers to choose the wrong income-driven repayment plan. The choice of income-driven repayment plan depends on the borrower’s specific circumstances and goals.
If the borrower’s goal is to have the lowest monthly payment, the choice of income-driven repayment plan matters.
- The Pay-As-You-Earn (PAYE) repayment plan will have the lowest monthly payment (10% of discretionary income) and shortest repayment term (20 years), with a standard repayment cap on monthly payments and a way to avoid the marriage penalty (e.g., if a married borrower files separate returns, the loan payment will be based on just the borrower’s income). But, eligibility for this repayment plan is limited. To qualify, borrowers must have at no loans prior to October 1, 2007 and at least one loan disbursed on or after October 1, 2011. Alternately, a borrower can qualify by being a new borrower as of July 1, 2014.
- If the borrower does not qualify for PAYE, then either Income-Based Repayment (IBR) or Revised Pay-As-You-Earn (REPAYE) repayment will have the lowest monthly payment. The choice of IBR vs. REPAYE depends on the borrower’s personal circumstances. REPAYE has a marriage penalty even if the borrower files separate returns and does not have a cap on the monthly loan payment. IBR does not have a marriage penalty, but does cap the monthly loan payment at the standard payment amount. The payment under IBR is 15% of discretionary income and the payment under REPAYE is 10% of discretionary income. Thus, the choice of IBR vs. REPAYE depends on whether the borrower is or expects to get married and whether the borrower expects their income to increase significantly over the repayment term.
The U.S. Department of Education has been steering borrowers to REPAYE, even when the borrower’s personal circumstances suggest that PAYE or IBR is a lower-cost repayment plan.
If the borrower’s goal is to reduce the total payments on their loan, a standard repayment plan might yield a lower total cost. This depends on whether the borrower’s debt will be paid off in full before the borrower reaches the end of the 20 or 25-year repayment term on the income-driven repayment plan.
If a borrower is pursuing public service loan forgiveness, choosing a qualifying repayment plan with the smallest monthly loan payment will maximize the amount of loan forgiveness. Otherwise, choosing a repayment plan with the highest monthly payment the borrower can afford will save the most money on interest.
Borrowers should calculate what their monthly loan payment will be under each of the income-driven repayment plans, and consider how that monthly payment might change if they get married, have a big increase in salary or go to graduate school. They should also try to estimate the total loan payments over the life of the loan, to determine which repayment plans will yield the most and least expensive options.
Error: Paying More than Required
Borrowers in an income-driven repayment plan should pay the minimum amount required by the repayment plan, and not a penny more.
Paying more than the minimum when using an income-driven repayment plan can cause the borrower to pay more than is required. The monthly payment under an income-driven repayment plan is based on the borrower’s income, not the amount they owe.
Income-driven repayment plans are for borrowers who are struggling financially. If the borrower can afford to pay more, they shouldn’t be in an income-driven repayment plan.
If the borrower is pursuing public service loan forgiveness, paying more than required will reduce the amount of forgiveness for which they are eligible.
Error: Using Deferments and Forbearances
Most borrowers in an income-driven repayment plan should never use a deferment or forbearance.
The economic hardship deferment can count toward the 20 or 25-year repayment term under an income-driven repayment plan, but not for public service loan forgiveness. Other deferments and forbearances do not count toward the 20 or 25-year repayment term or public service loan forgiveness.
But, even though the economic hardship deferment might count toward the repayment term for an income-driven repayment plan, it should not be necessary to reduce the monthly payment after a change in the borrower’s income.
Income-driven repayment plans based the monthly student loan payments on the borrower’s income, not the amount they owe. If a borrower’s income has dropped, the borrower can appeal to the loan servicer midyear to have the loan payments based on the borrower’s new income, instead of waiting until the next annual income certification date. If the borrower’s income has dropped below 150% of the poverty line (IBR, PAYE and REPAYE) or 100% of the poverty line (ICR), their monthly payment will be zero, eliminating the need for a deferment or forbearance.
Error: Late Annual Income Certification
If a borrower fails to recertify their income information every year by the deadline, it can increase their costs.
This is the most common error, with half of borrowers missing the deadline.
If the borrower misses the deadline by more than 10 days, there are several negative consequences:
- The accrued interest will be capitalized, increasing the principal balance of the debt.
- The loans may be placed in an administrative forbearance of up to 60 days while the servicer processes the recertification documentation. Time spent in a forbearance does not count toward forgiveness of the debt.
- Also, if the annual certification documentation is submitted late, the servicer will place any payments that are overdue or would be due at the time the servicer determines the new payment amount into a forbearance.
- If the borrower does not submit the annual certification of family size, but does provide the annual certification of income, the servicer will assume a family size of one. This can lead to an increase in the monthly payment under an income-driven repayment plan. It may even cause a loss of eligibility for certain income-driven repayment plans if the borrower no longer has a partial financial hardship under this assumption.
- If the borrower does not submit the annual certification of income, the monthly payment may change. Under REPAYE, the monthly payment will be based on level amortization with a 10-year repayment term or the remainder of the REPAYE plan’s 20 or 25-year repayment term, whichever is less. Under ICR, IBR and PAYE, the monthly payment will be based on level amortization with a 10-year repayment term, but the loan amount that was owed when the borrower switched into ICR, IBR or PAYE. This may require more than 10 years to repay, if this loan amount is lower than the borrower’s current loan amount.
It is easy to recertify. Every borrower should put a reminder in their calendar, so that they don’t forget to recertify.
Error: Increasing Spending while under Income-Driven Repayment
Switching into an income-driven repayment plan may free up some cash flow in the borrower’s budget, since the monthly loan payment under income-driven repayment will be lower.
Some borrowers use this “savings” as an opportunity to spend more.
Instead, they should use the extra money to improve their financial situation, such as by paying down other debt or saving the money.
Borrowers who choose an income-driven repayment plan because they are struggling financially should use the extra money to pay off more expensive high-interest debt, such as credit cards and private student loans. Alternately, they could use the money to start building an emergency fund, so they have cash to cover living expenses if they lose their job.
Error: Not Planning for the Future Forgiveness Tax Bill
Unlike public service loan forgiveness, the forgiveness of a borrower’s remaining debt after 20 or 25 years in income-driven repayment is taxable under current law.
This substitutes a smaller tax debt for the borrower’s student loan debt.
While some borrowers will be able to get the IRS to forgive the tax debt because they are insolvent, some won’t.
Borrowers cannot count on Congress to change the tax treatment of the cancellation of remaining debt at the end of the income-driven repayment term.
Accordingly, it is important to save money to cover the cost of the future forgiveness tax bill.
Error: Failing to Reevaluate Use of Income-Driven Repayment
Certain major events – marriage, divorce or separation; birth, death or adoption of a child; enrolling in graduate school; or a big change in income – can affect the monthly student loan payment under an income-driven repayment plan.
A change in marital status can yield a big change in the monthly loan payment under income-driven repayment, especially if the borrower is in an income-driven repayment plan with a marriage penalty, such as REPAYE.
An increase in family size, due to an additional child, will lead to a decrease in the monthly loan payment under income-driven repayment. Conversely, the death of a child will lead to an increase in the monthly loan payment under income-driven repayment.
Enrolling in graduate school can increase the repayment term under REPAYE. If the borrower includes a federal student loan that was received as a graduate or professional school student (or a consolidation loan that repaid such a loan) in the REPAYE plan, the repayment term will increase from 20 years to 25 years. This matters mainly for borrowers who are not pursuing public service loan forgiveness.
A big increase in income can cause a big increase in the monthly loan payment under income-driven repayment, especially under the income-driven repayment plans that do not cap the monthly loan payment, such as ICR and REPAYE.
When one of these events occurs, the borrower should evaluate whether they should remain in the income-driven repayment plan or switch into a different repayment plan.
If the borrower experiences a mid-year decrease in income, the borrower should recertify their income early or appeal to the service to have their monthly loan payment adjusted to reflect the lower income.
If the borrower’s ability to repay has improved, it may be worthwhile to switch into the standard 10-year repayment plan.
Error: Getting Locked into Income-Driven Repayment
Borrowers can get locked into income-driven repayment after an extended period of negative amortization.
Interest continues to accrue under an income-driven repayment plan, even when the borrower’s payment is less than the new interest that accrues.
If the borrower were to switch into another repayment plan, this interest will be capitalized, increasing the amount of the debt. This can cause the monthly student loan payment to jump under the new repayment plan.
A big increase in the monthly loan payment may prevent the borrower from switching repayment plans because it will be harder for them to afford the new loan payments.
Thus, once a borrower is in an income-driven repayment plan, they get locked in, making it difficult for them to switch to a different repayment plan.
Error: Other Common Errors
Other errors are not specific to income-driven repayment plans, but rather affect borrowers in any repayment plan.
- All borrowers should sign up for auto-debit, where the monthly loan payments are automatically transferred to the lender.
- Never pay for help changing repayment plans. Borrowers can easily do this on their own, for free.
- Borrowers should always tell the lender about any changes in their contact information.