Beware Interest Costs When You’re on an Income-Driven Repayment Plan
Income-driven repayment (IDR) plans cap your monthly loan payments at a small percentage of your income, but they also can increase the total amount of interest you pay. Understanding how student loan interest works on IDR plans is key to deciding if you should enroll in any of the programs and in choosing a plan. Here are five facts about interest costs for income-driven repayment plans you need to know before signing up.
1. Income-driven repayment plans don’t affect your interest rate
An income-driven repayment plan won’t change your student loan interest rate. Switching to an IDR plan can lower the amount you’re required to pay each month, but it won’t impact your interest rate. Interest will be assessed and charged in the same way it was before you enrolled in the plan.
The only exception is if you choose to consolidate your loans before enrolling in income-driven repayment. In this case, the rate on your Direct consolidation loan will be the weighted average of the rates on your consolidated loans rounded up to the nearest one-eighth of a percent. This potential difference is minimal though, so your rate will effectively remain the same.
2. You’ll likely pay more in total interest on an IDR plan
Even though your interest rate won’t change on an IDR plan, you can wind up paying more in total interest charges over the life of the loan. This is because IDR plans extend your repayment terms, leaving you in debt for longer.
Plus, the lower monthly payments on an IDR plan won’t reduce your balance as quickly as a standard repayment plan. You’ll be charged interest on a balance that’s higher than it would be if you followed the traditional 10-year repayment schedule.
Take, for example, a comparison of interest costs on $25,000 in federal student loans. Assuming interest rates of 4.5% and an income of $30,000, the monthly payment on an Income-Based Repayment (IBR) Plan is $149 — that’s $110 less than the $259 payment on a Standard Repayment Plan.
Over the course of repayment, however, you’ll end up paying more than $3,800 extra in interest charges. To easily compare how IBR impacts your costs of borrowing, use our income-based repayment calculator.
3. Monthly payments don’t always cover interest charges
A standard repayment plan for federal student loans will get you out of debt within 10 years. Monthly payments are set to cover both interest charges and repayment of the principal within that time.
An income-driven repayment plan, on the other hand, is designed to have affordable monthly payments based on your current income. It typically won’t help you save on interest costs or get out of debt faster.
In fact, many IDR participants will have monthly payments that are less than what they owe on interest alone. Low payments that result in unpaid interest is called negative amortization.
Say you qualified for a $50 monthly payment under an IDR, for example, but your student loan results in $80 of interest charges per month. That leaves $30 of unpaid interest each month that can accrue and be capitalized, or added to, your student loan balance.
4. Unpaid interest will be added to your balance
Unpaid interest charges will accrue and eventually be added to your student loan balance. This capitalized interest will become part of a new, higher balance that will increase the amount on which you’re charged interest.
Certain actions can trigger a capitalization of unpaid interest on an IDR plan. Each income-driven repayment plan has its own rules and limits on when and how this unpaid interest is capitalized.
| Income-driven repayment plan | When will unpaid interest be capitalized? | How much interest can capitalize? |
|---|---|---|
| Pay As You Earn (PAYE) | If you no longer qualify for reduced payments under PAYE or leave the plan | 10% of your initial debt balance when you enrolled in the plan |
| Revised Pay As You Earn (REPAYE) | If you fail to recertify your income or leave the plan | No limit |
| Income-Based Repayment (IBR) | If you no longer qualify for reduced payments or leave the plan | No limit |
| Income-Contingent Repayment (ICR) | Annually | Annual capitalized interest is limited to 10% of initial debt balance upon enrollment |
5. Some IDRs help cover unpaid interest
Some federal student loans and IDR plans will help you cover the costs of negative amortization.
If you have subsidized loans, for instance, your student loan interest subsidy might apply to any interest not covered by your monthly IDR payments. On IBR, for example, the U.S. government will pay this leftover interest for the first three years of enrollment.
The REPAYE plan also offers its own interest benefit, which pays 50% of monthly unpaid interest on unsubsidized loans. This benefit also is applied to subsidized loans when the 100% subsidy expires after three years.
Is an income-driven repayment plan worth it?
Which IDR plan is most beneficial will largely depend on your debt and financial situation.
But before signing up for one, keep in mind that it will typically lead to much higher interest costs. If you can afford the standard 10-year plan — or even make extra payments on your loans — you could get out of debt sooner and save money on interest.
Ultimately, you need to understand the potential costs of an IDR plan and compare your student loan repayment options to make your best decision possible.