Income-Based Student Loan Repayment: Pros and Cons
It’s the time of year when students across the country graduate with four year degrees. While it’s exciting to finally be done with studying, the majority of today’s college graduates have to deal with the burden of student loan repayment starting six months after graduation. For many graduates who aren’t even sure how they will manage to pay their rent, let alone high student loan minimum payments, this transition into true financial independence can certainly be stressful and uncertain.
If your student loans are federal student loans, then income-based student loan repayment programs are something you may want to consider, at least for the time being. Here’s a basic overview of what income-based student loan repayment programs are, and a brief snapshot at some of the pros and cons involved of these repayment options in order to help you make informed financial decisions.
What are income-based student loan repayment programs?
Income-driven student loan repayment programs are designed for federal student loan borrowers, (for example Direct Subsidized, Direct Unsubsidized, Direct PLUS, and Direct Consolidation loans that did not repay any PLUS loans made to parents), which are based on financial factors such as family size and total adjusted income as reported to the IRS.
The two most common types of income-based repayment programs are Pay As You Earn (PAYE) and Income-Based Repayment Plan (IBR). In both cases, the borrower’s monthly payment will generally be about 10% of their discretionary income, but never more than the 10-year Standard Repayment Plan amount. What this means is that if a borrower suddenly has a large increase in income, their student loan monthly payments will only increase to the monthly payment amount that would normally be required on a standard 10-year repayment plan.
For more extensive information pertaining to the different types of federal student loans that qualify for these repayment plans, refer to the short and concise Federal Student Aid’s information guide here.
As is the case with any financial decision, federal student loan borrowers should be aware of the pros and cons of income-based student loan repayment programs in order to make a well-informed decision.
- Much lower monthly payments than under 10-year (or even extended) student loan repayment plans – Based on finances following the months (and years) immediately following graduation, lower student loan payments can relieve an immense amount of pressure to be able to pay the bills.
- Student loan forgiveness – Both PAYE and IBR repayment plans have 20 year repayment periods; any remaining loan balances under these plans will be forgiven by the federal government after making on-time payments for 20 years.
- Added protection for unemployment or loss of hours – Should you ever find yourself in a period of unemployment or significant cut in work hours, your minimum payments under these plans will consequently decrease. For instance, if your income is $0, then your student loan payments will also be $0 and will not reflect poorly on you or negatively impact your credit score.
- More interest accrued – Because your payments are lower, the amount of interest accrued on your principal balance will consequently increase. In fact, your monthly payment under one of these repayment plans may not even cover interest, and your total balance will actually increase each month.
- Having to remember to report financial information – In order to continue to qualify for these repayment plans, you will need to remember to submit updated financial and tax information on an annual basis to your student loan provider. This may be a minor inconvenience, but can certainly add to the already headache-inducing tax filing. If you do forget to submit this updated information, you may be dropped from your repayment plan and as a consequence have your monthly payments dramatically increase.
- Longer loan repayment term – Instead of paying off your student loans in 10 years, you will now be making payments for 20-25 years under one of these repayment plans. While the lower payments may be nice, the amount of time your loans will follow you will become much longer.
- Taxes on loan forgiveness – While the idea of having your student loans forgiven may sound nice, these forgiven balances will be considered taxable income by the IRS.
The final word
There are certainly some wonderful benefits of entering into a federal income-based student loan repayment programs, such as PAYE or IBR, which can help relieve some of the pressure of paying off student loans after college. If you end up changing your mind in a year or two and wish to pay off your student loans in a shorter amount of time, you can always change your repayment plan with your student loan provider – it’s good to know that alternative options exist, and entering into one of these federal repayment plans can at least be a temporary solution in times of financial hardship.