Income-Based Repayment and other income-driven repayment plans keep your monthly student loan bill affordable by capping it at a portion of your disposable income. While this can sometimes mean the difference between keeping up with payments and defaulting on your loans, there are also income-based repayment disadvantages that you should know about.
From facing higher interest costs to lengthening your repayment period, the potential negatives should be understood by all borrowers interested in income-based repayment plans. Here are five drawbacks to consider before you switch plans:
1. You’ll stay in debt longer
2. You might pay more in interest
3. You’ll have to re-certify your repayment plan every year
4. You could end up with higher payments
5. You might get hit with a big tax bill
Is Income-Based Repayment a good idea?
The government currently offers four income-driven repayment plans:
- Income-Based Repayment (IBR)
- Income-Contingent Repayment (ICR)
- Pay As You Earn (PAYE)
- Revised Pay As You Earn (REPAYE)
These plans limit your student loan bills to 10% or 15% (up to 20% for the ICR plan) of your discretionary income, depending on which plan you use. But as alluring as it may be to have a smaller payment, note that they also extend your repayment from the standard 10 years to a new term of 20 or 25 years.
True, you can generally get any remaining loan balance forgiven at the end of those 20 to 25 years, but often you’ll be doubling or more than doubling your time in debt.
“Borrowers will be in repayment for up to 20 or 25 years, which means they will still be repaying their own student loans when their children enroll in college,” said Mark Kantrowitz, publisher of education finance website Savingforcollege.com.
In most cases, the longer you have student loans, the more interest will accrue. If you extend your repayment terms on an income-driven plan, the overall cost of the loan will rise. And although the remainder will be forgiven, there’s no guarantee you’ll still owe much by the time your repayment term ends.
Let’s say, for example, you have $30,000 in student loans at a 6.80% interest rate. On a 10-year repayment plan, you’d spend $11,429 total in interest. Extend that to a 20-year repayment plan, however, and you’d end up paying $24,960 in interest.
So unless your income is small enough that the bulk of your debt ends up forgiven, the longer schedule could very well cost you more money. You can run the numbers for yourself by visiting our calculator page and selecting the calculator that matches the plan you’re considering.
To get on an income-driven repayment plan, you need to submit an application and provide proof of your income and family size. And you’ll have to do it again and again, every year, recertifying all your information until your debt is paid off.
On the Standard 10-year plan, you can pretty much set up auto-payments and forget about your loans. But with income-driven repayment, you’ll need to keep track of your documentation and fill out the recertification on time.
“One of the most significant disadvantages of income-driven repayment plans is the need for annual paperwork to remain in the programs,” Kantrowitz said, adding that “the form is also excessively complicated.”
To stay on Income-Based Repayment and similar plans, you’ll need to do more work than you would on another plan.
Each income-driven plan adjusts your monthly payments based on your discretionary income. As noted above, you’ll need to recertify your information on a yearly basis, and based on this, your payment may change as well.
If you start making more money, you will almost certainly end up with higher student loan payments. Fortunately, two of the plans — Income-Based Repayment and Pay As You Earn (PAYE) — never ask you to pay more than you would on the Standard 10-year plan.
However, the other two plans don’t place any limits on how much your monthly payment can be. In those cases, you could end up paying more than you would have on your original plan.
Similarly, if you leave an income-driven plan, your regular bill might rise as well.
“If a borrower wants to switch out of an income-driven repayment plan, there may be a cliff effect where the monthly payment increases significantly,” Kantrowitz said.
The prospect of eventual loan forgiveness for anything you still owe at the end of your 20- or 25-year term may sound very attractive.
But while your student debt may disappear, you could end up with debt of a different kind: a huge tax bill. Any forgiven balance is treated as taxable income, and you could end up owing thousands of dollars in income tax. And if you can’t afford that tax bill, you might find yourself under a new payment plan, sending monthly checks to the IRS.
Note, however, that some other forms of student loan forgiveness — such as Public Service Loan Forgiveness — are tax-free and not considered as income by the IRS.
None of these income-driven repayment disadvantages make using this option a bad idea. Depending on your income and other factors, you could reap huge benefits from Income-Based Repayment or a similar plan.
If you’re struggling to make your payments or hovering near student loan default, an income-driven plan could offer the relief you need. Additionally, the lower payments could free up some cash and allow you to grow your savings or pay off other debts, such as credit cards.
However, a quick review of your finances is worthwhile in order to see whether you these plans might actually make things worse. In such cases, you could be better off with a different money-saving strategy, such as refinancing your student loans.
Consider your current income, as well as what you’re likely to make in the future, to decide if the benefits of Income-Based Repayment (or other income-driven repayment plans) outweigh the disadvantages.
Kristina Byas contributed to this report.