Income-driven repayment plans are financial tools set up by the federal government to help hard-pressed borrowers manage their federal student loans. The plans tie your monthly payments to your actual income rather than a traditional calendar of fixed installments, so you may find yourself owing nothing when times are really tough times, only a little when they're a bit less hard, and more when they're easier.
Defaulting on your student loan can ultimately have serious consequences for your credit score – and therefore for your life chances – for at least seven years. And, of course, student debt is only dischargeable in bankruptcy in highly exceptional circumstances. This can make income-driven repayment plans financial life preservers for those who otherwise couldn't keep up with payments.
As with all government programs, these are surrounded by rules, regulations and eligibility criteria, and this article can only provide an overview. So don't get too excited about how a plan could help you until you've explored the topic more, maybe at the U.S. Department of Education's website. Still, nearly 4 million people have already signed up for the plans, so you stand a good chance of being helped.
1. Should I Have an Income-Driven Repayment Plan?
You'll likely need one of these plans if you're finding it extremely difficult or impossible to make monthly payments according to the student loan deal you signed up to because your income is too low to afford them. If your income is reasonably good, and you want to cut your payments to improve your lifestyle, you're unlikely to benefit and would probably be ineligible anyway.
The amount you have to pay is assessed on your actual earnings. The calculation is based on your "discretionary income," which the U.S. Department of Education defines as "the difference between your income and 150 percent of the poverty guideline for your family size and state of residence."
2. Which Plan Should I Choose?
There are three flavors of plans, and all of them cap your monthly payments at the sum that would normally be due under your original loan agreement:
- Income-Based Repayment plan (IBR plan) – You have to pay 10 percent of your discretionary income, unless your original loan agreement was dated on or before July 1, 2014, in which case you should pay 15 percent.
- Pay As You Earn Repayment plan (PAYE plan) – You have to pay 10 percent of your discretionary income.
- Income-Contingent Repayment plan (ICR plan) – The lesser of:
a) The amount you would be paying on a 12-year repayment plan with fixed monthly payments, adjusted according to your income, OR
b) 20 percent of your disposable income.
So let's look at an example for a recent IBR plan or a PAYE one, based on a single person living in one of the 48 contiguous states or DC. The federal poverty guideline for 2015 is $11,770, and 150 percent of that is $17,655. Your discretionary income is the difference between your actual income and $17,655. So, if you actually earn $20,000 a year, your discretionary income will be $2,345. Your student loan payments would be 10 percent of that, which is $234 a year, or $19.50 a month. If you earn $17,655 or less, your payments are zero.
In the event your financial circumstances take a sudden turn for the worse midway through a year, you can update your loan servicer right away. That should see your payments reduce more quickly than if you wait for your annual renewal.
3. What Does This Do to My Repayment Period?
Smart question. As with all loans, the smaller your repayments, the longer your debt hangs around. Here are the maximum repayment periods for each plan:
- IBR plan for new borrowers (after July 1, 2014) – 20 years
- IBR plan for borrowers with loan agreements dated on or prior to July 1, 2014 – 25 years
- PAYE plan – 20 years
- ICR plan – 25 years
4. What if I Still Owe Money at the End of My Repayment Period?
Suppose your income doesn't go up as quickly or as much as you hope, and you still have a balance at the end of the 20- or 25-year period your plan is supposed to last. This is the really good news: Your remaining outstanding debt is forgiven.
The only downside? The financial benefit you receive when the loan is forgiven may be taxable.
5. What's the Catch?
There's only one. As with a mortgage, auto loan or any other borrowing, the longer you owe money for, the more you pay in total interest charges. It's not that the interest rate itself is higher (it's generally not), but the period you're paying it for is extended.
6. What's Most Likely to Go Wrong?
Your income-driven repayment plan needs active management throughout its existence. Most importantly, it has to be renewed annually, and, if you fail to do this on time, your payments could automatically revert to those you would be paying under your original loan agreement. One borrower wrote to federal regulator the Consumer Financial Protection Bureau to complain his or her monthly payment "jumped from approximately $200 a month to $1,400 a month, causing me to go into overdraft on my checking account."
Worse, that borrower had submitted her renewal application within the period her loan servicer had recommended, and it was the company's rather than his or her fault that it hadn't been processed on time. The moral of this story is to open all the mail you receive from your loan servicer as soon as it arrives. That letter you're tempted to leave unopened may be a renewal reminder rather than a statement. And get your renewal application in as soon as you can (and always before the deadline) so your chances of getting caught up in an admin bottleneck are reduced.
Avoid that issue, and applying for your plan may turn out to be one of the most worthwhile financial moves you make in your life.