MintFamily with Beth Kobliner: Get Your Monthly Payments Under Control—Income-Driven Repayment Plans for Your Federal Student Loans

If you’re like the two-thirds of college grads who took on debt to pay for their degrees, you owe an average of about $30,000 in federal student loans. That means you’ll likely be facing steep monthly payments stacked against a low income after graduation. But there’s a way for some borrowers to avoid a lot of month-to-month aggravation: income-driven repayment plans. My fellow personal finance journalist Ron Lieber briefly touched on these plans in a recent New York Times piece (which includes a nifty new student loan calculator that the folks at the Times have just cooked up). I want to offer some details about how these plans can slash your monthly payments to the double digits and, eventually, wipe away your debt before it’s fully paid off.

Income-driven repayment was introduced years ago, but was spiffed up by President Obama in several ways. If your student debt load accounts for a big chunk of your discretionary income, you may be able to get your monthly payment reduced to far less than you’d owe under the standard plan. And lower monthly payments will enable you to pay your lenders on time—essential for keeping your credit rating healthy.

Of course, one worry for people considering these plans is: Doesn’t a lower payment now simply mean I will pay much more in interest over time? Here’s the real beauty of income-driven repayment plans as configured by President Obama: While your student loans may be projected to be paid back for longer, the plans allow your student debt to be totally forgiven after 10, 20, or 25 years, depending on the plan and a record of on-time payments. And that could mean major savings. The downside: In most cases, you will owe taxes on that unpaid debt when it’s forgiven.

So, what does all this mean, in real numbers?

Let’s take the example of Anna. She is a single freelance accountant, has $70,000 in loans from undergrad and grad school, earns an Adjusted Gross Income of $40,000, and is now entering repayment. Under the standard 10-year plan used by about two-thirds of borrowers, Anna would have to pay off her loans at a monthly clip of $796, paying a total of $95,502 over 10 years. Under 25-year extended repayment (a plan that does not tie payments to your income or offer loan forgiveness), Anna would pay $474 a month, for a total of $142,169. But if Anna enrolls in an income-driven plan called Pay As You Earn, she would make monthly payments for 20 years that start much lower, at $187. At that rate, she would pay $83,765, after which her unpaid loan would be forgiven. (Of course, since nothing about student loans is ever simple, Anna would need to pay tax on the forgiven amount. But even still, assuming Anna is in the 25% income tax bracket, she’d end up saving about $40,000 compared to extended repayment.)

I outline some details of these income-driven plans below, and more information can be found at IBRinfo.org or studentloans.gov. You should use the government’s Repayment Estimator to see if your combination of income and debt make you eligible for income-driven repayment, and, if so, which plan best suits your needs. If you’re eligible, you can enroll in one of these plans through your loan servicer, who handles billing for your federal loans and with whom you can switch your repayment plan at any time. (The government will help you find your loan servicer.) One hassle: You’ll have to requalify every year on your “enrollment anniversary” by updating your income information.

Remember that income-driven repayment is not a one-size-fits-all solution: Standard Repayment is always going to be the quickest way to pay off your federal debt. If you feel one of these plans might be right for you, it’s important to apply right away, before you’re in financial distress. If you’re in default on your loans—meaning you haven’t made a payment in nine months—you are not eligible for income-driven repayment.

• Pay As You Earn (PAYE) will theoretically save you the most money—but it’s also the pickiest when it comes to determining eligibility. You have to qualify for “partial financial hardship,” which means the monthly payment you would owe under the standard plan is too high relative to your income. (Don’t worry, the Repayment Estimator will calculate this for you.) Under PAYE, your payments are capped at 10% of what’s called your “discretionary income” (defined as your income minus 150% of the poverty guidelines for your family size—the Repayment Estimator will determine this, too), and loans can be forgiven after 20 years. Moreover, if you earn less than 150% of the poverty guidelines for your family size, you are not required to make payments at all.

• If you don’t qualify for Pay As You Earn, consider Income-Based Repayment (IBR). This plan caps payment at 15% of your discretionary income and offers loan forgiveness after 25 years. You will still need to pass that “partial financial hardship” rule to qualify.

• If the above plans aren’t in the cards, try Income-Contingent Repayment (ICR), which works differently than PAYE and IBR. With this plan, your monthly payment is based on one of two formulas (whichever produces the lower monthly payment): either what you’d pay under a 12-year standard repayment plan adjusted for your income, or 20% of your discretionary income. Like IBR, ICR offers loan forgiveness after 25 years. Most borrowers qualify for ICR, but your payments will generally be higher than under the other income-driven plans.

• Separately, make sure you look at Public Service Loan Forgiveness (PSLF) if you’re committed to a career in public health, teaching, law enforcement, the military, or the nonprofit sector. Good deeds do go unpunished—actually, they’re rewarded—when it comes to student loans: This program promises to wipe away your remaining federal student debt after you’ve been in repayment for 10 years, with no taxes owed on the forgiven amount. If you opt for Public Service Loan Forgiveness, sign up with ICR, IBR, or PAYE (whichever plan you qualify for) so that you’re paying as little per month as possible during your 10-year term. Going back to the example of Anna, let’s say that instead of being an accountant she is a public school teacher, qualifying her for Public Service Loan Forgiveness. If she combined that program with Pay As You Earn, Anna would be forgiven thousands more dollars tax-free than she would without signing up for PSLF—and 10 years sooner at that.

Here’s the bottom line: One in 10 borrowers defaults within two years of entering repayment nowadays, spelling financial disaster. You need to pay off your loans on time, every month. And income-driven plans are designed to help even the lowest-income borrowers do just that.

Beth Kobliner is the author of the New York Times bestseller Get a Financial Life, and is currently writing a new book for parents, Make Your Kid a Money Genius (Even If You’re Not), to be published by Simon & Schuster. She was recently appointed by President Obama to the President’s Advisory Council on Financial Capability for Young Americans. Visit her at bethkobliner.com, follow her on Twitter, and like her on Facebook.

© 2014 Beth Kobliner, All Rights Reserved