Almost 1 in every 5 American adults has some form of unpaid student debt, according to the latest estimates from the Federal Reserve and Experian. The total student debt balance is currently $1.4 trillion to $1.6 trillion—roughly equivalent to the gross domestic product of South Korea or Australia, and more than the GDP of Florida.
Although private student loans are growing in popularity, federal student loans are still the dominant type of loan—accounting for 92.3% of all outstanding student debt, according to MeasureOne.
The good thing about federal student loans is the range of options available to borrowers after finishing the degree attached to the loan. Possibilities include debt consolidation, loan forgiveness, and income-driven repayment. In this article we’ll explore income-driven repayment.
What is an Income-Driven Repayment Plan?
Income-driven repayment, also known as income-based repayment, is a federal government program that resets your monthly student loan payment at an amount that is affordable based on your income and family size. It differs from regular federal student loans (or any type of loan, for that matter) in 1 main respect: your monthly payment is based primarily on how much you earn each month, and not on how much you owe.
Federal Student Aid, an office of the US Department of Education, offers 4 types of income-driven repayment plans: Revised Pay As You Earn Repayment Plan (REPAYE), Pay As You Earn Repayment Plan (PAYE), Income-Based Repayment Plan (IBR); and Income-Contingent Repayment Plan (ICR). The plans differ in terms of how much of your discretionary income goes toward your monthly payment—although it usually ranges from 10%-20%.
Fortunately, StudentLoans.gov has a repayment estimator that tells you which programs you qualify for and how much you’ll pay based on: your loan information; your family size and marital status; and your taxable income (minus certain reductions). The Federal Student Aid website offers comprehensive information about applying. Before filing out your application, please read on for the pros and cons of income-driven repayment.
"If they are having trouble repaying their loans, they should investigate what kinds of repayment structures are available to them. If they have a federal loan, there are lots of very flexible repayment provisions that are based on income. These really should work for most people. For that sort of thing, contact the loan servicer and find out what you might qualify for."
-Kevin Walker - CEO and Founder at Collegefinance.com
Pros of an Income-Driven Repayment Plan
Lower monthly payments. The most obvious reason to apply for income-driven repayment is to pay less each month. If you’re unable to meet your current payment, what you need is a reduced payment—and income-based repayment is one way to achieve this. As mentioned, income-driven plans usually take about 10%-20% of your discretionary monthly income, i.e. income remaining after deduction of taxes and expenditure on necessary items like rent, mortgage payments, utilities, and food.
More time to pay your debt. Unlike federal student loans, which must usually be paid by the 10-year standard repayment schedule, income-driven repayment terms range from 20 to 25 years. This buys you time to get your finances in order and pay off that debt.
It’s flexible. Another way in which income-based repayment differs from other options is that it automatically gets re-evaluated every year. If your income falls or your family grows, your monthly payments get reduced. Conversely, if your income goes up, you may find yourself paying more (which is a good thing, right?).
Cons of an Income-Driven Repayment Plan
Higher overall interest payments. One of the golden rules of a loan is that, all other things being equal, the longer the term the higher the overall interest paid. By extending the term from 10 years to 20-25 years, the total interest paid across the life of the loan can increase significantly. A reduced monthly payment exacerbates this situation even further. Paying off the balance more slowly leaves more principal to be paid in the future—and more interest to be applied to that principal.
Negative amortization. This is probably the biggest but least-understood risk to income-based repayment. According to the Investopedia definition, negative amortization is an increase in the principal balance of a loan caused by a failure to make payments that cover the interest due. The remaining amount of interest is added to the loan’s principal. Income-driven repayment plans are tied to the borrower’s income and family size, with no rules about meeting all the interest. If you can’t afford the interest, but need to keep making monthly payments in order to stay eligible for benefits such as loan forgiveness, you may have no choice but to accept negative amortization. But if you can afford to do so, it would be advisable to pay more and avoid adding to the principal.
It can involve a lot of red tape. While there are potential benefits to having your plan re-evaluated every year, the flipside is the potential headache. First, the law requires borrowers on income-based repayment plans to submit new documentation every year. Completing the process online is supposed to take about 10 minutes, but it also requires filing proof of income. A change in your household situation, such as getting married or deciding to start/stop filing taxes separately with a spouse can also complicate things. If things get too complex, you may need the help of a tax advisor.
Our Top Choices for Student Loan Refinance
Working with well-known and reliable loan providers in the industry, Credible makes it easy to find the right loan solution. It offers a flexible service with competitive rates and many loan options for borrowers looking to finance their degrees or refinance existing student loans. The service does not directly provide loans, but works with a network of reputable lenders to provide top rates and conditions for all borrowers.
Earnest is a student loan refinancing company that is focused on issuing flexible loans to meet their customers’ needs. Earnest’s low rate student loan refinancing has base terms of 5, 10, 15 or 20 years. However, what makes them unique is that Earnest lets customers customize their loan terms to the time frame, giving customers the exact monthly payment that perfectly fits their budget. Earnest’s customers save over $17,000 on their total student loan payments on average.
When to Consider Income-Based Repayment
Despite the obvious downsides, there are certain situations in which it may be advisable to go for income-driven repayment for a temporary period of time.
- If you’re starting out in a profession such as medicine or law where you start with a low salary but know your income will increase exponentially in a few years, income-driven repayment is one way of keeping your loan in good standing for the time-being
- If you’re planning to eventually apply for public service or teacher loan forgiveness, the income-based option is again a good way of meeting minimum requirements for now.
- If you have other outstanding debts with higher interest rates, such as a personal loan, auto loan, or credit cards, you may want to move on to income-driven student loan repayment until you pay off all those other debts.
Finally, another reason to use income-driven repayment is if you’ve exhausted all other options and would otherwise have to forgo necessary expenses like rent or food. Thanks to income-driven repayment, holders of student debt need not face the choice between putting food on the family table or paying off federal loans. However, before rushing into income-driven repayment, first consider options like consolidation or refinancing.