NEW YORK (MainStreet) Behold the prudent federal student loan borrower: he borrows only what he really needs, and upon graduation, signs up for the most sensible loan repayment programs. In the case of borrowers with financial need, that usually means the income-sensitive programs, such as Income-Based Repayment (IBR) and Pay As You Earn (PAYE), which cap your payments at a small percentage of your disposable income. If you have no income, your required monthly payments could even be $0.
These plans sound like a slam dunk, right? Usually. But lost in the fine print are some hidden costs, such as the infamous "tax bomb," that can create thousands in unexpected costs. And the Obama Administration's recent budget proposes significant changes that, if passed, can sneak up on your wallet, too. Even the choice between PAYE and IBR can impact your financial future.
PAYE vs. IBR Payments
When income is tight, it can make sense to select the plan with the lowest monthly payment. In most cases, that plan is PAYE, which caps payments at 10% of your disposable income, says student loan expert and author, Heather Jarvis.
"There are lots of different repayment plans people can consider, but PAYE is generally the only repayment plan that can beat IBR in terms of monthly payments," she says. "PAYE offers significantly lower monthly payments and earlier forgiveness for those borrowers who qualify."
So, why aren't most federal loan borrowers on PAYE, rather than IBR? The problem, says Jarvis, is that with a few exceptions, only people without federal loans issued before October of 2007 qualify.
"It's important to know that PAYE is limited to "new borrowers" and is only available for Direct Loans. Some people (who borrowed after October 2007 and before July of 2010) may be able to gain access to PAYE by consolidating into a Direct Consolidation Loan."
Keep in mind that consolidation has its costs, too: your loans' average interest rate is rounded upward when consolidated. If you have a substantial loan balance, the extra tenths of a percentage point can add up to thousands.
Crunching the Numbers
While the difference between payments at 15% of disposable income (IBR) versus PAYE's 10% may not seem very large, the total impact on your finances may be greater than you think.
Take, for example, a professional school graduate with $100,000 in loans at 7.3% and a $50,000 Adjusted Gross Income. The Department of Education estimates that on IBR, this person would pay approximately $246,000 over the life of the loan. Meanwhile, on PAYE, the total payments would've totaled only about $117,000, for a difference of nearly $130,000 in payments.
But the difference is actually much greater, since many smart borrowers would've put that extra money to good use, such as paying debt, buying a house, or investing. If this borrower could've put the hundreds of dollars in monthly PAYE savings (the DOE estimates savings of about $140 to $400 per month) toward investments, retirement savings, or other wealth-building uses, he'd potentially have hundreds of thousands of dollars more at the end of the repayment period in addition to the original savings.
Even worse, says Jarvis, IBR payments last 25 years to PAYE's 20.
"PAYE offers significantly lower monthly payments and earlier forgiveness for those borrowers who qualify," she said.
The Tax Bomb
One of the greatest draws of both PAYE and IBR is the loan forgiveness offered on any outstanding balances remaining after 20 or 25 years of payments, respectively. But the potential "tax bomb" assessed on forgiven loan balances looms over borrowers with hefty balances.
"It's real," says Jarvis, "The forgiven loan balance is treated as income in the year it's forgiven."
Using our example above, you'd be liable for taxes on over $128,000 of loan forgiveness if on PAYE. On IBR, you'd owe taxes on over $5,000. That huge difference in taxes can eat away significantly at any potential savings from PAYE over IBR, so be aware of its overall financial impact.
Obama's Proposed Changes Good or Bad for Borrowers?
The Obama Administration's 2015 budget proposal aims to resolve the PAYE-IBR disparity by eliminating IBR and making PAYE available to all federal loan borrowers. Before you uncork the champagne and start celebrating, says Jarvis, remember that this is still just a proposal, and as with most budget proposals, will likely see several revisions when it faces Congress.
"President Obama supports expanding PAYE to those of us with older loans but the idea faces opposition in Congress due to the projected costs," Jarvis says.
Even if the proposal passes in its entirety, some of its provisions are likely to be unpopular amongst many borrowers, such as a reduction of the amount of Public Service Loan Forgiveness available to borrowers working in the non-profit and public sector. Under the current IBR and PAYE plans, workers in these generally lower-compensated sectors could enjoy forgiveness of any remaining student loan balances after 10 years of payments. The proposal aims to cap the forgiveness at about $57,000.
According to Jarvis, the following changes have been proposed:
- Eliminating the standard payment cap under PAYE. Under IBR and the current PAYE, borrowers would never pay more than they would under a standard, 10-year repayment plan. This proposal removes that cap, so that if you find yourself earning a lot more later in your career, you might end up with payments greater than you would've paid had you been under a traditional plan. This is problematic, because as interest is capitalized to your loans, they balloon in size and may increase your total repayment cost significantly.
- Calculating payments for married borrowers filing separately on the combined household Adjusted Gross Income. In some instances, this may mean larger payments than you would've paid separately.
- Capping Public Sector Loan Forgiveness (PSLF) at the aggregate loan limit for independent undergraduate students (currently $57,500). As described above, this limits the amount of loans forgiven for those in public sector or non-profit jobs. Will some students be less likely to follow non-profit or public service careers?
- Establishing a 25-year forgiveness period for borrowers with balances above the aggregate loan limit for independent undergraduate students. For borrowers with high balances, this extends the PAYE re-payment period to 25 years, instead of the current 20.
- Capping the amount of interest that can accrue when a borrower's monthly payment is insufficient to cover the interest. Many student loan borrowers unable to make full payments would benefit from slower growth in their loan balance.
Again, while these are merely proposals, the changes could catch some borrowers by surprise. (A petition to maintain the current PSLF benefits is making the rounds amongst some borrowers.) Jarvis believes there's likely sufficient precedent to protect existing borrowers from some of these changes (such as their signed Master Promissory Note, for example), but newer borrowers or those switching plans may be in for some surprises if all or part of these changes are enacted.
And as with any potentially unexpected expenses, it's better to be aware than find yourself caught unprepared and liable for additional costs. Speak with your loan servicer to get the latest details.
Janet Al-Saad is the founder of the Five Ten Twenty Club, a website designed to help you improve your finances $5, $10 or $20 at a time.