Is an Income-Driven Repayment Plan the Best Choice for You?

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If you’re like many people, your student loan debt can be overwhelming. The average Class of 2017 is carrying $39,400 in student loans. Nearly five million borrowers in the United States were in default on their loans in the third quarter of 2017.

But there is a way to reduce burdensome student loan payments. If you feel like you’re drowning in student loan debt, an income-driven repayment plan could be a lifesaver.

Income-driven repayment plans cap your monthly payments at a certain percentage of your discretionary income. Unlike standard plans, which break up the loan repayment over 120 months, income-based plans extend payments to 20 or even 25 years, reducing your monthly payment and freeing up money in your budget.

While these plans can be really helpful for some people, it’s important to understand all the pros and cons before you sign up.

4 types of income-driven repayment plans

There are four separate income-driven repayment plans available to federal student loan borrowers:

  • Revised Pay As You Earn (REPAYE)
    Under a REPAYE plan, your payment is capped at 10% of your discretionary income. For undergraduate loans, your terms are extended for 20 years. If any of your loans were for graduate school, your repayment term stretches to 25 years.
  • Pay As You Earn (PAYE)
    With PAYE plans, your payment is 10% of your income but never exceeds what your payment would be under a standard repayment plan. Your repayment term is 20 years.
  • Income-Based Repayment (IBR)
    If you’re a borrower after July 1, 2014, your payment is capped at 10% of your income, and you will make payments for 20 years. If you borrowed before that date, your term will be 25 years.
  • Income-Contingent Repayment (ICR)
    On an ICR plan, you pay the lesser of either 20% of your discretionary income or what you would pay with a fixed plan over twelve years. If you qualify for the 20% option, you can make payments for up to 25 years.

If your loans are not completely paid off at the end of the repayment term, the remaining balance is forgiven on all four of these plans.

The benefits of an income-driven repayment plan

Kathryn Moore, a Philadelphia-based supply chain specialist, says income-driven repayment plans made higher education — including a Master’s degree — possible for her. As a first-generation student paying her own way, her entry-level salary was small but her earning potential is expected to rise as she progresses up the corporate ladder.

“I took out about $75,000 in student loans between college and graduate school,” says Moore. “My monthly bill on a standard 10-year repayment plan was over $1,300, which ate up a huge chunk of my $35,000 annual salary. Under an income-based repayment plan, it’s just $270; that difference makes it possible to pay the rest of my bills.”

For graduates right out of school who are underemployed or are in low-salary fields, their monthly paycheck is often not enough to cover their living expenses and their debt. Income-driven repayment plans can help those individuals manage their debt burden and keep up with the rest of their needs.

Monthly payments are determined by a variety of factors, including your income and family size. Each year, you need to apply for the alternative payment option. If you lose a part of your income or have a baby, your monthly payment can drop even further.

The downsides of income-driven repayment plans

However, income-driven repayment plans are not without their drawbacks. These repayment plans are not for everyone, according to Zakiya Smith, a strategy director at the Lumina Foundation, a nonprofit focused on improving access to education.

A former senior policy advisor to the White House and the U.S. Department of Education, Smith cautions that while alternative repayment options can be beneficial, they can be extremely expensive since you pay interest for the duration of the extended repayment period.

“If you’re really struggling to pay for the essentials, like rent and food, income-driven plans make sense,” says Smith. “But it’s important to understand that you will pay back much more in interest with an extended repayment term. If things are tight but you can free up money by cutting back on eating out or eliminating cable to stay on a standard 10-year plan, that’s better for you in the long run financially.”

Additionally, Smith notes that many people do not understand how taxes come into play regarding student loan forgiveness. If you are under an income-driven plan like PAYE or REPAYE, after a particular period — usually 20 or 25 years — the balance of the loans is forgiven.

“But what people don’t know is that the forgiven loan isn’t just free money,” said Smith. “The amount that is forgiven is taxable as income. You could end up owing thousands back to the federal government at tax time.”

For Orlando-based graphic designer Jerry Daniels, that turned out to be too true. After years of making regular payments, the balance of his loans was forgiven. But he had a huge surprise when his lender sent him a 1099-C form and he found out he owed the IRS over $15,000.

“I was completely shocked,” said Daniels. “I felt like I paid the price for making my life easier at first.”

If you’re planning on receiving loan forgiveness after 20 or 25 years on an income-driven repayment plan, make sure to prepare for one last payment in the form of a tax bill.

Choose what’s right for you

Cutting your monthly payment way down is tempting, but remember to think of the long-term implications, too. If you opt for an extended repayment plan when you don’t really need it, you could end up paying thousands more in interest over time.

Plus, any forgiven balance is treated as taxable income, which could end up being a major bill after 20 or 25 years of repayment.

Before making changes to your student loans, make sure you’ve researched all your options, including consolidation and student loan refinancing.

Whether or not an income-driven repayment plan makes sense for you is dependent on your unique situation, so consider your loan amount, income, and alternative options for loan forgiveness before signing up for an extended plan.

Rebecca Safier contributed to this article.

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