Maybe you’re just getting out of school and you got a letter from your student loan servicer about repayment, or maybe you read on a blog or in the newspaper about an income-driven repayment plan. Maybe you’re not really sure what they are, how they work, or what they could mean for you. Let me give you the fundamentals.
First, let me explain the naming. “Income-driven repayment” is an umbrella term for three different repayment plans available to those with federal student loans:
- The Income-Based Repayment Plan
- The Pay As You Earn Repayment Plan
- The Income-Contingent Repayment Plan
Notice how the names of all three plans reference “income” or “earnings”? Well, that’s because, under these plans, your payment amount is based on how much money you make. To really understand the differences between income-driven and “traditional” repayment plans, you must understand how your payment amount is calculated under each type of repayment plan.
How Monthly Payments Are Calculated
“Traditional” repayment plans are those such as the Standard and Extended Repayment plans. These traditionalists take three variables—the interest rate, principal balance, and repayment period—and determine the least amount of money that you can pay each month to pay the loan off by the end of the repayment period (usually 10-25 years, but sometimes as much as 30 years). This means that borrowing more, having a higher interest rate, or having a shorter repayment period will increase your monthly payment (and vice versa). Those three variables are all the traditional repayment plans care about—they don’t care if you can afford that payment, they just want your loan to be paid off within a specific time frame.
Income-driven repayment plans take these variables and stand them on their heads. These plans say, “you’ll pay what you can afford: a percentage of your ‘discretionary income’” (hint: that’s something less than your total income). Depending on the plan, that may be 10%, 15%, or something else. What you ultimately pay depends on the plan you choose and when you borrowed, but in all cases, it should be something you can afford. Sometimes, it can be as low as $0 per month.
Student Loan Forgiveness and the Income-Driven Repayment Plans
Because your payment under the income-driven repayment plans is not calculated to ensure that your loan is paid off within a specific time frame, the plans have another special feature: loan forgiveness. These plans do have a repayment period—20 or 25 years. However, it’s not the point at which your loan must be paid off; instead, it serves as a counter toward loan forgiveness. Under these plans, if your loan is not repaid in full at the end of your repayment period—20 or 25 years—then the remaining balance will be forgiven. Let me be clear: this is not to say that everyone who selects an income-driven repayment plan will receive forgiveness. You may end up paying your loan off in full before you’re eligible for some forgiveness. Because your payment is based on your income, your payment changes when your income rises (or falls). Your income is the “x” factor, and we don’t know what will happen to it in the future. Under these plans, then, you may pay your loan off in full, or not, but the income-driven repayment plans are happy either way.
What else affects whether you will receive loan forgiveness? Well, it’s those familiar variables of loan balance and interest rate. Remember, interest accrues each day on whatever your principal balance is. The income-driven repayment plans do not change this fact. So, even though your payment isn’t related to how much interest is accruing, that interest still accrues and must still be paid before you can pay down the principal balance on your loan. Ultimately, because your payment is less than it would be under another plan and may even be less than the amount of interest that accrues on your loan, then you will pay down your principal balance more slowly and increase the likelihood of receiving loan forgiveness. This also means that your loan will cost you more over time. Does this mean that you shouldn’t choose an income-driven repayment plan? Of course not! But, I wouldn’t be doing my job if I didn’t explain that there was some sort of cost to receiving this benefit.
To be a good bureaucrat, I need to give you a few disclaimers before I wrap this up:
- If you receive loan forgiveness under an Income-Driven Repayment Plan, it may be considered taxable income by the Internal Revenue Service.
- The Income-Based and Pay As You Earn Repayment plans both have an eligibility criteria that tests to see whether you “need” to enter the plan—this test checks how much federal student loan debt you have relative to your income.
- There are loan-based eligibility criteria that I didn’t even mention, but know that these plans are only available for federal student loans—loans made under the Direct Loan and Federal Family Education Loan Programs, to be specific.
- If you are married, how you file your federal income tax return matters; sometimes it matters a lot.
How to Apply
In closing, let me give you some actionable steps that you can take:
- Use the Repayment Estimator to model your eligibility and payment amount for an income-driven repayment plan.
- If you have still questions, call your loan servicer and discuss whether one of these plans is a good fit for you.
- Apply online at StudentLoans.gov. Because this stuff is complicated, check the box that allows your loan servicer to put you on the income-driven repayment plan with the lowest monthly payment amount.
The English language was not marred through the use of acronyms in this blog post. Ian Foss has worked for the Department of Education since 2010, and, thanks to the Income-Based Repayment Plan, has been able to eat more than just ramen noodles since he finished school.