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Student Loan Income-based Repayment Plans: Friend or Foe?

by | Mar 21, 2019 | Debt

The government does a terrible job of educating student loan borrowers. Like any loan, you’re required to look at pages and pages of fine print before you sign up for the loan. But who reads that stuff?

Certain student loan repayment plans can be dangerous if you’re not careful. And that’s what I want to teach you about this week.

First, I’ll take a quick look at Standard repayment plans. Then we’ll look at Income-based repayment plans, both the good and the not-so-good.

Standard Repayment Plans

Standard repayment plans act like any other loan. You have a payment plan for X number of years and at the end of that plan, your loans are paid off. The government offers three types of Standard plans depending on your situation.

  • Standard Repayment Plan: Pay back your student loans in 10 years with a set monthly payment. When I say “set monthly payment” I mean the payment is the same the entire time you’re paying the loan back. (e.g. $300 a month, each month for 10 years)
  • Extended Repayment Plan: Borrowers can extend their repayment term out to 30 years, depending on how much their total debt is. The monthly payment is the same during the entire term.
  • Graduated Repayment Plan: Payments start out low in the early years. But they steadily rise over time. These loans are good for people who expect their income to increase quickly.

Standard plans are not good for borrowers looking to get their loans forgiven. In fact, these repayment plans are ineligible for Public Service Loan Forgiveness (PSFL).

Instead, these plans are best for people with a reasonable amount of student loans. By reasonable, I mean the total amount of your student loans is LESS than what you make each year.

These plans will keep the total cost of your loan down (principal + interest payments.)

The Basics of Income-based Repayment Plans

Student loans have become a huge burden for many borrowers. In response, the government created repayment plans to make these loans “affordable.”

The basic idea behind income-based repayment plans is to limit the payment to a certain level of your discretionary income. Usually 10% or 15%.

Under these plans, there are three variables that go into computing your monthly payment:

  • Your income, as measured by your Adjusted Gross Income on your latest tax return
  • Your household size (you + your spouse + any kids you have living at home)
  • The Federal Poverty Level, depending on the state you live in

Here’s an example of how payments are calculated under these plans:

Example borrower:

  • Adjusted Gross Income is = $75,000
  • Married with two kids…Household size = 4
  • Lives in the Lower 48 States
  • Borrower selects a plan that limits her payment to 10% of discretionary income
  • Student Loans Oustanding = $100,000 with interest rate of 6.0%

The payment formula is this:

[Adjusted Gross Income – (Federal Poverty Level x 150%)] x 10%.

Our borrower would have an annual payment of [$75,000 – ($25,750 x 150%)] x 10% = $3,637.50

To get the monthly payment, we simply take this amount divided by 12 = $303.13 per month.

By comparison, if this borrower was on a Standard 10-year repayment plan her payment would be $1,110.21.

Income-based Repayment Plan Payment = $303 per month
Standard Repayment Plan Payment = $1,110 per month

Which payment would you choose? The lower payment, of course! But like all good things, there’s a catch.

Negative Amortization: Public Enemy #1

Many times, the monthly payment on an Income-based repayment plan is so low that it doesn’t even cover the interest you’re being charged on the loan. In fact, if your income is low enough, your monthly payment might be $0!! Crazy, no?

Let’s go back to that example above to see how this might happen. Our borrower had $100,000 of student loans at a 6.0% interest rate. That means that every month, they were being charged $500 of interest.

$100,000 Student Loans Outstanding @ 6.0% Interest = $500/mo in interest

Now, look at the income-based monthly payment we calculated above for our borrower. You’ll notice that the payment is only $303 a month.

That means: $303/mo payment < $500/mo interest

What happens to that $197 of interest the borrower doesn’t pay each month? Answer: it gets ADDED to the amount they owe on their student loans!

In the financial world, we call this “negative amortization.” Negative Amortization means that your monthly payment is LESS than the amount of interest that accrued on your loan. For student loans, the government calls this “Unpaid Accrued Interest.”  

Watch what happens to your Unpaid Accrued Interest on an Income-based repayment plan:

Notice what’s happening here? 

  1. Your loan balance never goes down
  2. The amount of “Unpaid accrued interest” you owe goes up month after month

That Unpaid Accrued Interest is real money that you’ll have to pay back. After 10 or 20 years on a repayment plan like this, it’s not uncommon to owe 50% or more than what you started out owing, all because of this Unpaid Accrued Interest.

Negative Amortization is very dangerous. In fact, Congress banned the practice at credit card companies as part of the Card Act of 2009. So why does the government allow student loans to accumulate negative amortization? Good question!!

The point is: you have to be VERY careful if you’re using an income-based repayment plan. You can end up owing a lot more in the future than you do today!

When an Income-based Repayment Plan May Make Sense

Given what we know about income-based repayment plans and the dangerous negative amortization they can create, why would anyone choose one?

In my prior student loan post I talked about the 4 options you have to get rid of student loans:

  • Pay them back
  • Have them forgiven
  • Becoming disabled
  • Dying

Assuming Options #3 and #4 are unattractive to you, that leaves you with only two options: pay them back or have the loans forgiven.

But what if your student loan debt is so high relative to your income that you have little hope of paying them back? An extreme (but not uncommon) example would be someone who has $200,000 of student loans but makes “only” $75,000 per year.

Under a Standard repayment plan (assuming 6.0% interest) the monthly payment would be $2,220 per month! Even if they got on an Extended repayment plan that stretched their time to pay back to 20 years, the payment would still be over $1,400 a month.

Someone making $75,000 per year is taking home (roughly) about $4,500 per month after paying tax, Social Security, and Medicare. Paying $2,200 or $1,400 a month on student loans will be too much to handle.

That eliminates Option #1 (pay them back), leaving us with Option #2 – have the loans forgiven.

Income-based repayment plans are most useful when you’re trying to achieve loan forgiveness. The reason is simple: loan forgiveness might be your only way out of a big student loan problem. An Income-based repayment plan coupled with a loan forgiveness strategy can get you out of your student loan mess.

I’ll talk more about loan forgiveness next week.

Here’s the takeaway:
If your student loan balance is way higher than your annual income…
…and the monthly payment under a Standard repayment plan is too high for you…
…then you can think about entering an Income-based repayment plan with the idea that…
…you’ll get a lower, more manageable monthly payment…
…and be on track to have your loans forgiven in 10, 20, or 25 years, depending on the plan.

There are 4 Income-based Repayment Options for you to choose from. I’ve attached a summary sheet that you can download HERE.

But if you want to dig into these student loan repayment options further, I’ve created a Student Loan Repayment Plans Guide that you can download by clicking on the image below.

It’ll do a deeper dive into the repayment options for your Federal student loans.

Conclusion: Choose Your Student Loan Repayment Plan Wisely!

Your head might be spinning after reading this post. I know the subject of student loans is complicated. But if you have them, you MUST know what you’re dealing with.

My #1 advice to anyone who has a lot of student loans is to contact a financial advisor who has expertise in dealing with them. They can help you assess all of your repayment strategies.

But here are my general rules-of-thumb:

  • If your student loan balance is close to or below your annual income, get on a Standard repayment plan. It’ll be cheaper and faster to get rid of your student loans than horsing around with an Income-based plan. The only caveat here would be for those of you in public service (like teachers) where there might be some loan forgiveness opportunity.
  • If your student loan balance is (meaningfully) higher than your annual income, then you might want to consider an Income-based repayment plan. But remember, you MUST marry this plan with a strategy to either have your loans forgiven or to make higher payments in the future. If you don’t, you can end up with a much bigger problem down the road!

Next week I’m going to discuss loan forgiveness. If you’ve lost hope trying to pay back your student loans, please tune in!

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