Student Loans: Income Based Repayment (IBR) and Pay As You Earn (PAYE)

With graduation out of the way and the six-month grace period approaching its end, it’s important to figure out what student loan repayment plan is best for you. The first thing you need to do is find out exactly which loans you have and in what amounts by visiting the National Student Loan Data System (NSLDS). For any private loans, you should run a credit report to get this information if you have not tracked it along the way. With your loan balances available, the next step is to pick a repayment plan. This is important because if nothing is done on your end, you will be placed by default on the standard 10-year repayment plan, which will result in the highest monthly payments. Many graduates will not have the means to service their student loans on the standard repayment plan, so understanding the two major and most popular repayment alternatives the government has provided will be beneficial.

Income Based Repayment (IBR):

• What it is: IBR caps your monthly payments at 15 percent of your discretionary income, the difference between your adjusted gross income (AGI) and 150 percent of the poverty guideline for your family size and state of residence.
• What loans qualify: direct subsidized and unsubsidized, subsidized and unsubsidized federal stafford, all PLUS loans made to students (not parents), consolidated loans (direct and FFEL) made to students (but only from the time of consolidation)
• How to qualify: To qualify for IBR, you must demonstrate a partial financial hardship. A partial financial hardship is demonstrated when your annual amount of money owed on your eligible loans for a particular year, if it were to be calculated based on the standard 10-year repayment plan, is greater than 15 percent of the difference between your adjusted gross income (AGI) and 150 percent of the poverty line for your family size in the state where you live. In other words, if the amount you will owe each year exceeds 15% of your discretionary income for the year, you’re set. The whole point of switching to this plan, after all, is because you are unable to make the payments necessary on the standard repayment plan. The partial financial hardship calculation is just a fancy way to establish that.
• Annual disclosures: If you quality for IBR, each year you will have to provide documentation on the two factors considered in making the calculation above: that year’s AGI and family size. If you do not, your payments will shift back to what they would be on the standard 10-year repayment plan. This must be done even if there are no changes to either so that your monthly payments can be recalculated to the same amount again.
• Benefit: After 25 years of monthly payments under IBR, your remaining loan balance is forgiven (but the forgiven amount is taxed).

Pay As You Earn (PAYE):

PAYE is a new and even more merciful version of IBR. However, only “new borrowers” qualify for PAYE and only for direct loans. A new borrower is a student that did not owe any money on any federal student loans as of Oct. 1, 2007 and received a disbursement of a direct loan on or after Oct 1, 2011. Because PAYE functions the same as IBR, here are the differences:

• What it is: PAYE caps your monthly payments at 10 percent of your discretionary income, not 15 like IBR.
• What loans qualify: direct subsidized and unsubsidized, direct PLUS loans made to students (not parents), direct consolidated loans (direct and FFEL) made to students (but only from the time of consolidation)
• How to qualify: Assuming you are a new borrower and only have direct loans, you must demonstrate a partial financial hardship. This is no different than IBR, except it uses the 10% figure as opposed to the 15% under IBR.
• Annual disclosures: Just like under IBR, annual updates to your AGI and family size will be necessary if you want to avoid being switched over to the higher standard repayment plan monthly payments.
• Benefit: After 20 years of monthly payments under PAYE (shaves 5 years off of IBR), your remaining loan balance is forgiven (but the forgiven amount is taxed).

To switch to either plan if you qualify, you have to alert your loan servicer and provide them with the necessary documentation. An important benefit of being on either IBR or PAYE is that the monthly payments made under either repayment plan qualify for the Public Service Loan Forgiveness (PSLF) program (which is a special loan forgiveness program for direct loans only for individuals working full time for the government, 501(c)(3)s and certain other positions). This may be particularly valuable for those graduates that obtain such employment in the future.

PAYE and IBR – A Few Comments:

Although both repayment options are beneficial in that they allow any graduate with a partial financial hardship to avoid complete financial ruin, for most graduates qualifying for either repayment plan is like waiving the white flag. What in reality does a partial financial hardship mean? It means you are not earning enough money to service your student loan amount on a standard 10-year repayment plan, a situation that most likely did not cross your mind when those loans were being taken out. 10 years is a lot of time to pay off your student debt, so if you are incapable of financially servicing your loans within that time frame there are two possibilities. On the one hand, you have a modest student loan amount but your employment status is either severely underemployed or unemployed. On the other, you have a significant student loan amount and you may be fully employed, underemployed, or unemployed. The first position is obviously more positive, as qualifying for IBR or PAYE is simply a means to allow you to stay financially afloat until you gain employment that can service your student debt. That is the ideal scenario IBR and PAYE were enacted to cover. However, the latter position is a much bigger problem.

For those in the second category, unless your employment situation (or, in the case of those already fully employed but still qualifying, your financial situation) drastically improves and you can manage to pay off your significant student loans with your future income, the monthly payments you will make on IBR or PAYE will most likely not even cover the interest accruing for the month. That means these student loans will just continue to climb in size until you reach a point where you may as well focus on paying as little as is legally required until forgiveness and preparing for the tax bomb in the process. Especially for those with six-figure student debt unable to make dents in the principal balance on IBR or PAYE, after some time the remaining balance will equal more than the sum of what you will wind up paying with your monthly payments for 20 or 25 years (depending on the plan) and the 33% tax hit you will have to cover under current law once the loans are forgiven. At this point, it makes sense to prepare for dealing with the latter than it is to still be focused on trying to cover your entire principal because it makes much more financial sense. When exactly is the turning point? Using a net present value calculator will help you figure this out.

On the brighter side, this is something that will not be applicable to anybody a few years into IBR or PAYE unless they have extreme student loan debt off the bat and are facing prolonged unemployment, but it is something to think about if your employment or financial situation does not improve after some time and your student loan principal balance is snowballing. Hopefully, after a few years of building up experience and securing stable employment, most graduates will realize IBR and PAYE’s ideal scenario and this is not a calculation graduates will have to worry about. One can hope, at least. For more information on either plan, visit our IBR + PAYE FAQ. For a table with some potential monthly payment amounts, also check out StudentAid.

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