How Does the Federal Loan Interest Subsidy Work?
While you’re probably aware that income-driven repayment plans can lower your student loan payments, you might not know that some of them come with an interest subsidy.
What’s an interest subsidy? It’s a benefit that the government provides by paying off some or all of your student loan interest.
If your loans are on income-driven repayment, the government might cover some of the interest that accrues. However, this student loan interest subsidy is not available for the entire length of repayment.
Here are four issues you should know about:
Depending on your income, your monthly payment under an IDR plan may not be enough to pay off the accrued interest. This is called “negative amortization.”
In this case, the government might cover at least some of your interest for a certain period.
Role of IDR plans
If you can’t afford your federal student loan payments on a 10-year standard repayment plan, an income-driven repayment plan may be a solution. With IDR, the government looks at your discretionary income and family size to determine your monthly payment. Your repayment term is set at 20 or 25 years, depending on your loan. If you qualify, it can result in a significantly lower monthly payment.
However, under an IDR plan, interest continues to accrue. Plus, because the repayment term is longer, interest has more time to add up — you could end up paying thousands more over the duration of your loan. Additionally, as debt is forgiven at the end of the term with these plans, if you have a remaining balance, you could be required to pay tax on any amount that was forgiven.
Which loans are eligible?
Only certain types of student loans are eligible for income-driven repayment plans and the interest subsidy.
The following loan types are eligible:
- Direct subsidized loans
- Direct unsubsidized loans
- Direct PLUS loans for graduates or professional students
- Direct consolidation loans
Direct PLUS loans for parents are eligible for the income-contingent repayment plan if you consolidate them into a direct consolidation loan.
You cannot access the interest subsidy if you have private student loans.
Borrowers taking advantage of three of the four IDR plans are eligible for a student loan interest subsidy:
How much interest the government covers varies by plan.
If your monthly payment doesn’t cover the interest, the government will pay all the interest on your subsidized loans — including the subsidized portion of a direct consolidation loan — for up to three consecutive years. After, it will cover 50% of the interest throughout your term.
For example, if your monthly interest charges are $40 but your payment only covers $25, the government will pay the $15 difference for the first three years. After that, it will pay $7.50 (half).
If you have unsubsidized loans, the government will pay half of the remaining interest during your loan term.
Any borrower with eligible federal loans can qualify for REPAYE. Undergraduates get a 20-year repayment term, while students with graduate loans get 25 years. You’ll generally pay 10% of your discretionary income.
PAYE and IBR
If you have loans in a PAYE or IBR plan, the student loan interest subsidy works differently.
When your monthly payment does not cover the interest on your subsidized loans, the government will pay your remaining interest for up to three consecutive years. You’ll be on the hook for any interest that accrues after those three years.
If you have unsubsidized loans, the government will not cover any of the interest. If you leave either plan or no longer qualify to make income-based payments, your interest will capitalize.
You get a 20-year repayment term under the PAYE plan. With IBR, it’s 20 to 25 years, depending on when you took out your loans. With both plans, you typically pay 10% of your discretionary income, though it can be 15% with an IBR plan if your loans were disbursed before July 2014. However, with both PAYE and IBR, you’ll never pay more than what you would under a standard repayment plan.
Income-contingent repayment (ICR)
For borrowers on an income-contingent repayment plan, your loans are not eligible for the student loan interest subsidy.
With ICR, your repayment plan term is 25 years. You’ll pay the lesser of 20% of your discretionary income or what you would on a fixed repayment plan over 12 years (adjusted for income).
Like most programs that provide financial relief, you’ll need to apply to get an IDR plan.
Borrowers can apply through Federal Student Aid for free. Private companies can help, but they may charge a fee.
After your initial application, your work isn’t done. Participants are required to recertify every year and resubmit updated information about their income and family. If you don’t, you could lose your benefits, and your payments could go back to the amount you owed under the 10-year repayment schedule, potentially costing you a lot of money.
To know when it’s time to recertify, set a reminder in your calendar or smartphone.
Managing your student loans, particularly when you’re on an IDR plan, can be confusing and overwhelming. Understanding the terms of your loan and repayment plan — including how the interest subsidy comes into play — is essential to paying off your debt. A mistake can have you paying more than you need to or drag your debt out longer than necessary.
The student loan interest subsidy can provide aid to those struggling to keep up with their repayment. When the government chips in for interest charges, borrowers can save money and free up some much-needed cash flow.
Before choosing an IDR plan, evaluate all your repayment options and select the one that best fits your financial situation.