I decided to start giving advice about student loans, more specifically Student Loan Repayment after a client of mine had a horrible experience with Student Loan repayment plans.

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This family could have saved tens, if not hundreds of thousands of dollars if they only understood how repayment works. I felt awful for them, and for the last few years I have read and have tried to understand everything there is to know about Student Loan Repayment. I have been giving College Financial Planning advice for about 25 years and I can honestly say that in the last ten years or so student loan repayment has become so complex and confusing, you need a flow chart and several different calculators and excel spreadsheets to truly understand it.  I have filled out thousands of FAFSA’s and CSS Profiles and helped thousands of families through the college saving and financial aid process and I can honestly say without equivocation that Student Loan selection and repayment have become so complex that navigating the maze that is this process is the most complicated aspect of college financial planning. After reading through this, it will feel like you need a professional degree to understand how the student loan repayment system works!

 

When it comes time to pay back your student loans, you will find several different types of federal repayment plans. To complicate matters, you won’t find an option that stands out as the best. Some work great in certain circumstances, while others excel under different conditions.

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Selecting the best repayment plan requires more than just finding the one with the lowest monthly payment. Each one has unique features that can be positive or negative. The trick is to understand the differences between them.

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Finding the Best Federal Repayment Plan

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The best way to think about federal repayment plans is to consider them as tools in a toolbox. For example, a borrower might opt for a very low minimum payment plan to focus her efforts on paying down high-interest credit card debt. Once she pays off the high-interest debt, she can switch tools and turn to a more aggressive repayment strategy. In other words, there isn’t a “best” repayment plan. Instead, borrowers should focus on finding the plan that best fits the needs of their circumstances.

The key is to understand how you can use these tools. Once you understand the various options, you can pick the right tool for the job.

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The Standard Repayment Plan

The Standard Repayment Plan is the default plan that you are automatically placed in if none other is selected. It's also called the 10-year repayment plan.  when you get your first bill, the payment is probably based on this plan. It is also the repayment plan that usually has the highest minimum payment.

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The math on the standard repayment plan is simple. The repayment schedule is a simple loan repayment schedule, similar to a mortgage or any loan, it is calculated so that your loan is paid off in 10 years, 120 months.  The monthly payments stay level for the duration of the loan. Note: For borrowers who consolidate their loans, the standard repayment plan can have a 10 to 30 years repayment length.

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The Graduated Repayment Plan

This was enacted so that your payments are lower in the beginning years and then gradually increase as presumably your income does. Your monthly payments will increase every two years. The repayment length on the graduated repayment plan is ten years. However, if the borrower has previously consolidated their federal student loans, repayment can last for 10 to 30 years.

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While making smaller payments that gradually increase may sound appealing, this plan isn’t the best choice for most borrowers. This is because the graduated repayment plan doesn’t qualify for some of the best federal student loan forgiveness programs.  Which are discussed below. If you are looking for low monthly payments, typically you are better off with a income-driven repayment  (IDR)plan. Discussed below

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The Extended Repayment Plan

The Extended Repayment Plan has a 25-year repayment term. There are two options with this plan. The first offers fixed payments for the entire 25 years. The second, sometimes called the Extended Graduated Repayment Plan, offers graduated payments. In this plan, lower payments now and higher payments later, you will end up spending more on interest.

Like the Graduated Repayment Plan, the Extended Repayment Plan doesn’t qualify for some student loan forgiveness programs. So, again, there are better options. Even if you do not think you will qualify for loan forgiveness, you should choose an income-driven repayment plan (IDR) because it keeps the possibility open in the future. 

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These reason these plans are undesirable is that they were created way before the newer, better plans discussed below. 

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LOAN FORGIVENESS

Below is a discussion of the several different ways to get your loan FORGIVEN. That's right, FORGIVEN!

There are two paths to loan forgiveness Income-Driven Repayment Plans and Public Service Loan Forgiveness.

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Income-Driven Repayment Plans

The following repayment plans fall into the category of Income-Driven Repayment (IDR) plans.

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What makes these plans special is that monthly payments are based upon your income (AGI), not what you owe.

When you apply for IDR, the first step is income verification. This usually means a recent tax return or latest paystub. From this information, the loan servicer will calculate a borrower’s discretionary income. Discretionary income is the amount of money above the stated percentage of the federal poverty level. What happens is that you get to keep 100% of your salary up to 100% or 150%, depending on your plan, of the federal poverty level. This is the portion of your income that is considered non-discretionary and exempt from payment calculations.  Any income above this level is considered surplus and is termed Discretionary Income and is the income amount used to calculate your monthly payments. The federal poverty level changes each year and is based on your family size. If you do not have This is used to determine if you demonstrate Partial Financial Hardship.   Details like marital status and when you first borrowed a student loan will impact which Income-Driven Repayment Plan is best.

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IDR plans are eligible for student loan forgiveness after 20 to 25 years, depending on the plan. For borrowers with no hope of ever repaying their federal loans, this route to forgiveness offers a light at the end of the tunnel. The bad news is that the IRS considers forgiven debt to be income for tax purposes. Unlike Public Service Loan Forgiveness, there is no special exception for this type of student loan forgiveness. As a result, borrowers planning on forgiveness after 20 to 25 years need to prepare for a giant tax bill in that year. If you have $50,000 in student loans forgiven, the IRS will tax you as though you earned an extra $50,000 that year.

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The table below shows the basics of each Income-Driven Repayment Plan.

 

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* New Borrowers are defined as those who started borrowing after July 1, 2014.
** Borrowers with graduate school debt qualify after 25 years, while those with undergrad debt qualify after 20 years.

 

While our table and this discussion does cover the basics of the various IDR plans, there is fine print associated with each program that borrowers should understand. In some cases, this fine print prevents certain borrowers from applying to their desired repayment plan. In other cases, some repayment plans have unique perks that make them an ideal option. 

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Further Reading: Tips for Deciding Between IBR, PAYE, and REPAYE.

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Pay As You Earn (PAYE)

The “Pay As You Earn” Repayment Plan became available on December 21, 2012.  Only Direct Loan borrowers that took out loans after October 1st,2007, didn't have a student loan balance when taking out those loans and received a direct loan disbursement after October 1st, 2011.

The Pay As You Earn (PAYE) plan is one of the most popular federal student loan repayment plans. The government expects borrowers to pay only 10% of their discretionary income. If your payment amount is higher than the 10-Year Standard repayment amount you can switch plans any time. Furthermore, the government grants forgiveness after 20 years. The 10% and 20-year numbers are both the lowest available of all the IDR plans. The PAYE plan is also an eligible repayment plan for Public Service Loan Forgiveness.

You do have to demonstrate Partial Financial Hardship to qualify for PAYE. Basically, if your payments are lower in PAYE than in the 10-year Standard Repayment, you qualify, if the 10-year Standard payments are lower, you don't. That, in a nutshell is Partial Financial Hardship.

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One of the biggest advantages of PAYE is that it limits capitalized interest to 10% of your balance.  Capitalized interest is interest that is added to your balance and thus increases the amount you owe because now, interest is being calculated on the new larger balance. However, in IDRs this extra interest isn’t immediately added to your principal balance. Instead, the extra interest waits for an event to trigger interest capitalization. When the interest is capitalized, you start paying interest on the extra interest, which can cause a balance to grow fast.  PAYE is the only plan that gives this extra perk.

For example, if you have a $100,000 loan and have $15,000 in accrued interest. If you left PAYE or did not demonstrate partial financial hardship, only 10% or $10,000 of that interest would be added to your balance. Other plans would capitalize the whole $15,000, not only costing you that extra $5,0000 but interest would now be paid on $105,000. 

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Revised Pay As You Earn (REPAYE)

Like PAYE, REPAYE requires only 10% of a borrower’s discretionary income to be used to calculate payments. REPAYE is also eligible for Public Service Loan Forgiveness (PSLF). And, like PAYE, borrowers with only undergraduate debt can have their balances forgiven after 20 years. However, unlike PAYE, borrowers with graduate debt cannot qualify for forgiveness until they have made 25 years of payments.

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One of the special aspects of REPAYE is the way it treats unpaid interest. Unpaid interest is the interest your loan generates each month that your payment doesn’t cover. For example, if the interest on your loan each month is $200 and your payment is only a $100, you have $100 in unpaid interest. This means your balance is growing by $100 per month. REPAYE will help borrowers in that half of the unpaid interest goes uncharged. In our example, the loan balance would grow by only $50 per month, rather than $100. In all other IDRs, (except ICR) only unpaid interest on SUBSIDIZED loans is waived and only for first 3 years.

A negative to REPAYE is that it will include your spouse's income even if you file separately.

REPAYE is a good option for borrowers with loans too old to qualify for PAYE or IBR for new borrowers.

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Income-Based Repayment Plan (IBR)

Before PAYE and REPAYE, IBR plan was the best option for many borrowers. IBR might still be the best choice for some, but it is no longer the no brainer it used to be.

There are two forms of IBR: IBR New, for new borrowers and IBR Old. These two repayment plans work in the same manner, but there are three key differences. IBR New:

1. only charges 10% of discretionary income (IBR Old is 15%),

2. offers forgiveness after 20 years (IBR Old is 25), and

3. is only available to borrowers who started borrowing after July 1, 2014.

 

IBR used to be the best option for borrowers who weren’t eligible for PAYE because it is only open to new borrowers as of Oct. 1, 2007, who received a Direct Loan disbursement on or after Oct. 1, 2011. However, the creation of REPAYE has mostly fixed that issue because it does not have a “new borrower” limitation.

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Income-Contingent Repayment Plan (ICR)

This is most likely last on the list of desirability.  This is because ICR charges 20% of discretionary income and requires a full 25 years before student loan forgiveness is an option. As with all repayment plans, ICR is an eligible repayment plan for Public Service Loan Forgiveness purposes. There are some kinks to Standard Plan and PSLF eligibility, 

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However, sometimes ICR is going to be your best option because it will be your only option.  For example, parents who borrowed PLUS loans.  Parent PLUS loans are not eligible for any IDR plans. Graduate Plus loans are eligible under the other plans. The way to get PLUS loans eligible is to the PLUS loans into a federal direct consolidation loan, then they can become eligible for ICR and Public Service Loan Forgiveness. For many Parent PLUS loan borrowers, this is the best and only option.

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The table below tries to sum up as best as possible the above discussion.

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FFEL Loans, PLUS Loans, and Perkins Loans

The Federal Family Education Loan (FFEL) program and the Perkins loan program were two very popular forms of student loans for several years. Congress terminated the FFEL program and chose not to renew the Perkins Loan program.

 

As with the PLUS loan mentioned above, these loans may not be eligible for all repayment plans. The way to go about it, as mentioned above with the PLUS loan, is to consolidate the loans into a federal direct consolidation loan.

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We won’t be getting into the specific eligibility issue for these loan types, but borrowers with these loans should be aware of the potential problems. Handling these loans will be an extra complex task

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Does My Spouse’s Income Count in Repayment Plan Calculations?

Being married can make federal student loan repayment a bit more complicated. All student repayment plans look at a married couple's joint income, unless they file separate. You would need to work the numbers and see if you would be paying more in taxes when you file separate vs joint. You mostly always will. Then do the math to see what your student loan repayment would be. If it is worth paying more in tax and less in repayment, it may be worth it. This is a conversation you need to have with your tax preparer. This would only work if only one spouse has a student loan.

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This is how it works. The Department of Education looks at a couple’s ability to pay the debt and calculates discretionary income for the couple rather than the individual. For married couples who both have federal student loans, this means that the math will get a little more complicated. (As this is process is not complicated enough) When calculating payments, the Department of Education first figures out the couple's monthly payment. Then the DOE figures each spouse's ratio of their specific loan balance to the combined balance and determines how much each spouse is supposed to pay. I know this is kind of ridiculous as the money can be paid by either spouse. 

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For couples who both have federal student loans, the math might look like this:

Mr. and Mrs. Smith both sign up for IBR. Based upon their latest tax return, it is determined that 15% of their combined discretionary income results in a $600 per month IBR payment. Mr. Smith owes $60,000 on his student loans, while Mrs. Smith owes $30,000. Because Mr. Smith’s debt is twice the size of his wife’s, he will owe twice the payment. Mr. Smith will be charged $400 per month while Mrs. Example gets charged $200 per month. If Mr. and Mrs. Smith had equal debt, they would each be expected to pay $300 per month. Filing taxes separately wouldn’t save the couple any money; it just means the individual payments may be slightly different depending upon loan balances.

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Which Federal Repayment Plan is the Best Option?

There are a variety of federal repayment plans, and there are specific circumstances where each repayment plan excels.

Many borrowers may find that one plan is best initially but change plans as their repayment situation evolves.

The most important thing for borrowers is to understand the options available so that they don’t miss out on any savings opportunities.

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I told you this was as complex and complicated as it gets. I could have dedicated a whole web site to this subject alone. If you need help or would just like to discuss your repayment, feel free to schedule a Zoom or phone call with me please do so ASAP as my schedule fills up very quickly.  Click here to access my calendar https://calendly.com/michaelgaer/college-financial-planning