If you’re struggling with high student loan payments, switching to a Pay As You Earn (PAYE) plan could help make your payments more affordable.
PAYE is one of several income-driven repayment plans ideal for student loan borrowers with substantial debt and income too low to make required monthly payments. PAYE — along with the Revised Pay As You Earn (REPAYE) plan — does more than just reduce monthly payments. Opting for PAYE as your student loan payment plan could allow you to get part of your loan balance forgiven.
If you’re interested in having your student loan payment determined based on your income, read on to find out if PAYE is the right program for you.
What is Pay As You Earn?
“[PAYE is] a type of income-based repayment option where the amount you pay will be based on your discretionary income,” Michael Solari, the certified financial planner for Solari Financial Planning, LLC, explained. “The idea is that your payments will be less as you enter the workforce and gradually grow as you earn more.”
Federal student loan borrowers can choose the Pay As You Earn repayment program if they struggle to make normal loan payments. For qualifying borrowers, the repayment plan limits payments to 10 percent of discretionary income. At the end of a 20-year repayment term, any outstanding loan balance is forgiven as long as no payments were missed during the term.
PAYE differs from traditional Income-Based Repayment (IBR) because, depending upon the date your student loans were initiated, PAYE may cap loan payments at a smaller percent of income than IBR. This means monthly payments would be lower under PAYE. PAYE could also result in earlier loan forgiveness and better interest benefits for subsidized loans.
“If you qualify for PAYE, it is always superior to IBR,” said Chase Branham, an associate financial planner at Wrenne Financial Planning. However, qualifying for PAYE is more challenging, and loan consolidation may be required before you apply.
How PAYE lowers your monthly costs
The default repayment method for student loans is a 10-year Standard Repayment Plan. Payments are determined based on the loan balance under this option. Unfortunately, this isn’t affordable if your loan balance is high but your income is low.
Under PAYE, payments are not determined by your loan balance. Instead, PAYE will “reduce your payment to 10 percent of your discretionary income and will cap your monthly payment,” Branham explained.
The difference can be substantial. Consider the difference between PAYE and standard repayment if you have a $35,000 student loan balance at 5.7% interest; your income is $20,000 and grows 3.5 percent annually; and you are single.
|Repayment term||~ 10 yr.||~ 20 yr.||~10 yr.|
Often, your monthly payments under PAYE aren’t enough to cover interest accruing on loans. Under both IBR and PAYE, interest is not capitalized — or added to the principal balance — until you leave the repayment program, as explained by the Department of Education.
However, under PAYE, unpaid interest is only capitalized until the principal increases by 10 percent. This cap is a substantial benefit, because when interest is capitalized, you pay interest on the interest.
Under both IBR and PAYE, low payments also mean you often won’t repay your loan even after decades. You’ll have the remaining balance forgiven under both, as long as you made all your payments. PAYE provides for loan forgiveness after 20 years, while IBR payments on loans taken before July 1, 2014, must be made for 25 years before loans are forgiven. However, under both PAYE and IBR, you will have to pay taxes on the amount forgiven.
How your monthly payment is calculated under PAYE
To calculate your payment under PAYE, start by figuring out your discretionary income. Discretionary income is calculated by subtracting 150 percent of your state’s poverty level from your household income. State poverty levels are based on household size.
The poverty level for a household of one in New York was $12,060 in 2017, according to New York State Community Action Association. If you are single and living in New York with a $20,000 income, you would subtract $18,090 ($12,060*1.5) from $20,000. Your discretionary income would be $1,910. Your payments would be equal to 10 percent of this amount, so you’d owe $191 a year or $15.91 monthly.
The easiest way to calculate your PAYE payment — and the savings this payment method provides — is to use our Student Loan Pay as You Earn (PAYE) calculator.
To use the calculator:
- Input your adjusted gross income
- Select your family size
- Select your state of residence
- Input information about your current student loan balance and student loan interest rate.
- Estimate how much you expect your income to grow annually. The historical average income growth is around 3.5 percent, so that’s what our calculator defaults to.
The calculator will show your monthly payment, the forgiven amount, your savings, and the total amount repaid.
Pay As You Earn (PAYE) Calculator
Because your salary can change annually and PAYE is based off how much you make, you’ll need to recertify your plan each year. To recertify, you will need to provide proof of income. Your payment can go up as you earn more, but will not be more than 10 percent of your discretionary income.
Eligibility requirements for PAYE
PAYE requires that borrowers and their loans pass strict eligibility requirements. These include the following:
- The payment you’d owe under PAYE must be less than the payment you’d make if you were on the 10-year Standard Repayment Plan.
- You must be a new borrower as of October 1, 2007. You are not eligible if you had an outstanding balance on a Direct Loan before October 1, 2007.
- You must have received a Direct Loan disbursement on or after October 1, 2011.
- Your loans must qualify for a PAYE plan. Qualifying loans include Direct Subsidized and Unsubsidized Loans, Graduate PLUS Loans (but not Parent PLUS Loans) and consolidation loans made after October 1, 2011, as long as the consolidation loans do not include Direct or FFEL Loans made before October 1, 2007.
Pros of PAYE
PAYE has some significant benefits for borrowers. “The biggest pro is that you could have a ton of debt forgiven after paying 20 years,” Solari said. “For some that could be hundreds of thousands of dollars.”
Other pros, according to Branham, include “the ability to reduce and cap your payments, more favorable interest subsidies and capitalization rules than IBR, and flexibility to file taxes to keep payments low.”
Cons of PAYE
Cons of PAYE, according to Branham, include an interest rate that is less favorable than REPAYE, which could really hurt people with higher loan balances. Further, Solari points out that “since your payments are lower to start and paying over a longer period than a standard 10-year repayment, you will pay more interest.”
Solari also pointed out another big con: the risk that PAYE will not always remain an option. “These loan forgiveness programs were established under President Obama’s presidency. Any administration could take it away,” he warned. “Since you don’t get the benefit until you’ve paid in 20 years there is a big risk that the benefit will be there.”
REPAYE: A Pay As You Earn expansion
If you are not eligible for PAYE, you may be eligible for REPAYE, which was a Pay As You Earn expansion. “This program extends PAYE to all federal student loan borrowers,” explained Steven J. Richardson, a student loan lawyer at Richardson Law Offices. However, as Richardson explains in a comparison of PAYE and REPAYE, REPAYE has some cons that PAYE doesn’t.
In 2015, the Department of Education introduced the Revised Pay As You Earn program, also known as REPAYE. This modified version of PAYE allows more borrowers to qualify because you can become eligible regardless of when you took out your loans.
However, PAYE and REPAYE have important differences in how they treat spousal income and how student loan interest is treated.
Under IBR or PAYE, a student loan debtor can file taxes separately from a spouse and the spouse’s income won’t count for determining loan payments. This option goes away under REPAYE and a spouse’s income factors into determining monthly REPAYE payments.
REPAYE provides more help with interest to borrowers whose interest exceeds their monthly payments. If your loans accrue $100 in interest monthly and you pay only $50, your student loan balance would increase even as you made payments. REPAYE allows borrowers to have 50 percent of excess interest forgiven monthly. This means you’d only have $25 in monthly interest added to your loan balance each month if you paid $50 and monthly interest in the amount of $100 accrued.
However, there are no monthly payment caps under REPAYE, so your payments could end up much higher than they would on the Standard Repayment Plan.
Is Pay As You Earn right for you?
Whether PAYE is right for you or not is “highly borrower-specific,” Branham said. Factors Branham recommended considering include: “current loan balance, current income, expected future income, spousal income, spousal loan balances, and where you work.”
You’ll need to make sure you are eligible for PAYE, estimate current and future income, use our PAYE calculator to project payments, and decide which option makes sense both now and in the future.
Branham suggested PAYE could be a good option for eligible borrowers going for public service loan forgiveness, because it is the most aggressive option for lowering payments. “A good example of someone who might want to do PAYE would be a married borrower with high loan balances, who is going for PSLF, and whose spouse has no loans and high income,” he said.
However, if you have a higher income and neither spouse can take advantage of public service loan forgiveness or interest subsidies, Branham recommended refinancing over PAYE. “Basically at that point, you have to pay off loans, so refinancing to a lower rate can make sense,” he said.
It’s just a matter of doing the math to find out how to keep your overall costs of student loan repayment low and to find out if PAYE is the best answer for you.
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