Federal student loan repayment plans can be a lifeline for borrowers who are having difficulty paying their loans, but they also have their downsides.
Many federal student loans are eligible for a type of student loan repayment program called “income-driven repayment.” These plans can be a lifeline if you’re having difficulty budgeting or paying off student loans under a standard repayment plan. Sometimes an income-driven plan is required in order to make progress towards certain types of loan forgiveness programs, like Public Service Loan Forgiveness.
Here’s how these student loan repayment plans generally work. Income-driven plans use a formula to create a uniquely-tailored monthly payment based on your “Adjusted Gross Income” (AGI) and family size. You can enroll for up to 20 or 25 years (depending on the specific plan), at which point any remaining balance gets forgiven.
There are currently four major income-driven repayment plans, each with their own unique requirements and quirks: there’s Income-Contingent Repayment (ICR), Income-Based Repayment (IBR), Pay As You Earn (PAYE), and Revised Pay As You Earn (REPAYE). Each plan uses a different formula for calculating monthly payments, but they function similarly. And they all can have some major downsides.
Your loan balance may grow if you’re not covering accruing interest
Under an income-driven repayment plan, there is no requirement that your monthly payments cover all of the interest that accrues on your loans each month. Since the plans only factor in income and family size, they are blind to whatever is happening with accruing interest. That means that in some circumstances, borrowers can experience something called “negative amortization”—whereby the loan balance actually grows over time, even while you pay on time each month.
Here’s an example. Let’s say we have $40,000 in federal student loans at a 6% interest rate. And we’re on the IBR plan, with monthly payments of $50 per month. At 6%, interest is accruing on those loans at the rate of $200 each month. So while those $50 payments are certainly being applied to the loan balance, that balance is still growing by $150 per month.
This can be problematic if you’re only in an income-driven plan temporarily, such as during a period of reduced earnings. To repay the loan in full after the financial hardship ends, you’ll have a larger amount to repay. And even if you stay in the income-driven plan for the full 20 or 25-year term, runaway balance growth may be a problem even if there’s loan forgiveness at the end. Read on to find out why.
Potential tax consequences of forgiveness
Loan forgiveness sounds like a great light at the end of the tunnel if you’re on an income-driven plan, and it really can be. But under current law, any remaining balance that gets forgiven under these plans may be treated as taxable income for you—meaning you’ll have to pay income taxes on the amount forgiven, as if you “earned” that amount in income that year.
If you haven’t paid down their entire loan balance by the end of the 20 or 25-year repayment term, this could mean that “repayment” doesn’t actually end at loan forgiveness, because at that point, you’ll owe the IRS. Which can be a catastophic financial surprise in some cases.
Marriage makes things complicated
If you’re married while repaying your loans under an income-driven plan, the potential pitfalls get even trickier. That’s because marriage may impact your payments, depending on the plan you’re on and your marital tax filing status.
All of the income-driven plans will factor in your spouse’s income if you are married and you file taxes jointly. That means if your initial payments are based on your own income, you may experience a substantial increase in your payments after you get married.
However, three of the plans—ICR, IBR, and PAYE—allow borrowers to exclude their spouse’s income from consideration, if they file taxes as “married filing separately.” In doing so, borrowers can be treated as if they were single for purposes of calculating their monthly payments. This could lead to higher taxes, however, which may offset some or all of the savings.
Another income-driven plan, REPAYE, does not allow for the exclusion of spousal income from consideration, even if you’re filing taxes separately from your spouse. Even though REPAYE is generally cheaper than IBR, that means that some married borrowers would actually have a lower payment on the more-expensive IBR plan, because IBR allows for the exclusion of spousal income by filing taxes separately.
Deadlines and paperwork headaches
When you’re on an income-driven plan, your monthly payment doesn’t last forever. It lasts for a maximum of 12 months at a time. Towards the end of that 12-month cycle, borrowers must affirmatively renew the plan through a process called “re-certification,” which basically involves completing an application and submitting documentation of income. This can usually be done online.
However, if you miss your deadline, payments may skyrocket, and any outstanding interest may “capitalize” (meaning it gets added to the principal balance), leading to major financial consequences. It’s certainly possible to get back onto the plan again or re-certify late, but it can be a tedious and sometimes lengthy process.
Income-driven repayment is an important option for borrowers, but make sure it’s right for you. Check out the U.S. Dept. of Education’s overview of these plans, or learn more about student loan repayment before making a decision.
Adam S. Minsky, Esq. is an attorney with a practice devoted entirely to helping student loan borrowers. He practices in Massachusetts and New York.
Any third-party resources or websites referenced above are not under Society of Grownups control. Society of Grownups cannot guarantee and are not responsible for the accuracy of the resources, websites, or any products or services available through such resources or websites.
While Society of Grownups hopes the information is useful, it’s only intended to provide general education. It’s not legal, tax, or investment advice, and may not apply or be useful to your specific financial situation. If you need recommendations geared to your personal financial situation, schedule time with a financial planner professional.