[This is the second installment in a series examining repaying student loans. Part I was a best practices guide for repaying student loans.]
Pay As You Earn (PAYE) was introduced in December 2012 and has been widely touted as one of the best options for those struggling to pay back their student loans. Why is this? PAYE is an income-driven payment plan for federal student loans that caps the monthly payment amount at 10 percent of your discretionary income.
The U.S. Department of Education considers discretionary income to be “the difference between your income and 150 percent of the poverty guideline for your family size and state of residence.” So let’s do some math using the following assumptions:
- A new graduate
- Who attended a public, four-year institution
- Has the average (according to the Department of Education) student loan balance of $26,946
- Is single
- Makes $35,000 per year
- Lives in the lower 48 states, where the 2015 poverty guideline for that family size is $11,770
To determine this person’s discretionary income, you take the salary and subtract 150 percent of the poverty guideline (so, $17,655), to get $17,345. That works out to about $1,445 per month. Now, to determine their monthly payment under PAYE, you take 10 percent of that, which is $145. That’s over $125 less per month than the amount under the standard plan, which is $272. Plus, if this person loses their job, their required payments could be as low as $0 per month.
The problem with PAYE
The problem with PAYE is that in addition to meeting the income requirements, “you must also be a new borrower as of Oct. 1, 2007, and must have received a disbursement of a Direct Loan on or after Oct. 1, 2011.”
To be considered a new borrower, you must have had no outstanding Direct Loans or FFEL Program loans prior to the 2007 eligibility date.
That means if you have been out of school for awhile but are still struggling with loans, you’re left out of the PAYE loop entirely.
In that case, your best option is Income-Based Repayment (IBR), which caps monthly payments at 15 percent of discretionary income. Using our example above, that amount would be $217 per month, almost $75 more per month than that lucky duck on PAYE.
Obviously, this isn’t a perfect comparison. Hopefully, the person on IBR graduated with less debt, has been making payments longer, and is making more money by now. But under the apples-to-apples comparison here, PAYE beats the pants off IBR.
Introducing Revised Pay As You Earn (REPAYE)
Recognizing that PAYE wasn’t helping everyone who was struggling, in June 2014 President Obama directed the Department of Education to take further action to help student loan debtors. The result is Revised Pay As You Earn (REPAYE), which takes effect in December 2015. Students in the Direct Loan program who meet the criteria can participate regardless of when their loans were issued.
According to the Department of Education, REPAYE will:
- Enable 5 million additional borrowers to cap their monthly payments at 10 percent of their discretionary income, and
- Offer a new interest subsidy benefit so that balances don’t grow as rapidly for debtors whose required monthly payments don’t keep up with accruing interest.
However, it’s not all rainbows and puppies. From what I’ve heard about the plan, there are two big drawbacks to REPAYE.
Drawback 1: Married couples might pay more
Under REPAYE, both spouses’ income and federal student loan debt is considered when determining the monthly payment, regardless of whether they file federal tax returns jointly or separately. Under both IBR and PAYE, if spouses file separately, only the applicant’s income and debt are considered. So if, for example, only one spouse has student loan debt and/or one spouse is a high earner, REPAYE might not result in the lowest monthly payment.
However, spouses filing separately can’t take the student loan interest reduction, which is valuable because it is an above-the-line deduction, meaning that you can take it in addition to the standard deduction even if you don’t itemize. So if you had previously been filing separately to qualify for IBR and you and/or your spouse’s payments would be lower under REPAYE, you can probably file jointly and get the student loan interest deduction as well.
Drawback 2: No monthly payment cap
Under both IBR and PAYE, the monthly payment is capped at what it would have been under the standard repayment plan. REPAYE doesn’t have a monthly maximum payment, so if your income takes off, you could wind up paying more per month than you would under the standard plan. Potentially significantly more. And if you switch from REPAYE to another plan to avoid that outcome, any outstanding interest will be capitalized.
It’s unclear, but depending on whether the payment amount is based on your gross income or your adjusted gross income, it might be possible to artificially lower your income in a variety of ways. That would enable you to max out certain retirement vehicles as well as HSA and 529 accounts while keeping your student loan payments low, so you don’t have to decide between investing and paying off student loan debt.
Other things to keep in mind
First, under any federal income driven repayment plan, whether it’s IBR, PAYE, or REPAYE, any unpaid balance would be forgiven at the end of the repayment term. However (and this is a BIG however), the amount that is forgiven is taxed as income. Depending on what marginal tax bracket you find yourself in 20 or 25 years down the road, that could mean a BIG tax bill. And if you think your student loan servicer is aggressive, wait until you owe money to Uncle Sam.
In other words, if you choose any of these plans, try and calculate how much you will owe in taxes upon forgiveness and stash that money in a high-yield online savings account. Since you don’t really have any way of predicting your income over a 20-year period or what tax rates will be two or more decades from now, good luck with that!
Second, because your minimum payments may not cover your interest, your balance may rise over the course of repayment. The interest rate subsidy under REPAYE should help with this, but it’s hard to predict in advance how much. So if the idea of potentially making payments for 20+ years without making any headway on your balance gives you the heebies, then psychologically speaking it may be better for you to tighten your belt in the short term and pay the debt off sooner.
However, you can always pay more than the minimum on any repayment plan. So if REPAYE would give you financial breathing room now, it may be a good idea to switch to the plan and then pay off your debt more aggressively down the road as you are able.
[Note: I am not a tax or student loan professional. Consult a tax professional and/or the Federal Student Aid website and/or your student loan servicer(s) before deciding what repayment plan is the best fit for you.]
That said, what are your thoughts on REPAYE? If you are eligible, will you be making the switch?