Pay As You Earn: The True Cost of Student Loan Forgiveness
When you’re struggling under the burden of federal student loans, the possibility of loan forgiveness sounds like a fantasy. But thanks to the expansion of the government’s income-driven student loan repayment plan called Pay As You Earn (PAYE), more borrowers are inching close to student loan forgiveness than ever before.
PAYE was previously only available to people who took out loans after October 2007, but last year, the Department of Education launched the Revised Pay As You Earn (REPAYE) plan, which expanded the program to all eligible borrowers regardless of when their loans were disbursed.
A leg up for those borrowers who have trouble making ends meet, PAYE and REPAYE limit monthly student loan payments to 10% of their discretionary income and, after 20-25 years (10 years if you work in public service), forgives the remaining loan balance.
How Does PAYE Work?
For those who qualify and sign on for PAYE, payments are generally around 10% of your discretionary income. If your income increases and your monthly payments get recalculated, your payments will never exceed what you would be paying under the standard repayment plan, as long as your income is still under the qualifying threshold.
So what’s the catch? For one thing, lower monthly payments will, of course, mean a higher accumulation of interest. And while your loan balance could be eligible to be forgiven in 20 years, that forgiveness in many circumstances is seen as income in the eyes of the IRS.
So if in 20 years you still owe, say, $20,000, even if the total balance is forgiven, you might have to pay taxes on that $20,000 the same year its forgiven.
Am I Eligible for a PAYE Plan?
Not everyone is eligible for the PAYE program. First off, PAYE only works for federal direct loans. And because PAYE was created for those struggling to meet loan payments, PAYE is only available to those who can demonstrate economic hardship. This makes sense, of course, because 10% of a high discretionary income would be a high monthly payment and over the payments of a federal standard plan.
PAYE plans are given to those whose monthly payments are lower than they would be on the standard 10-year payment plan.
Right about now you’re probably thinking, Lower payments and eventual loan forgiveness—where do I sign?
But there’s a catch. There’s almost always a catch.
While the idea of loan forgiveness may sound like the ultimate ‘get out of loan-jail free’ card, income-driven plans like REPAYE, PAYE and their predecessor, Income-Based Repayment (IBR), come with some less-than-obvious costs.
Costs Associated with PAYE and Income-Driven Repayment
In some cases, those costs outweigh the potential benefits—even the benefit of ultimate loan forgiveness. What costs should you be aware of when it comes to income-based repayment plans? Here are the big three:
1. The Straight Costs
Under an income-driven plan, lower student loan payments are primarily a result of lengthening your loan’s term from the standard 10 years to 20 or 25 years, depending on the plan. You still owe the same amount in terms of principal, but you’ll pay it off much more slowly and make a smaller dent—if any dent at all—in the principal with each payment.
In other words, an income-driven plan is a recipe for significantly higher interest costs than you would incur with a 10-year repayment plan. Plus, any loan balance forgiven at the end is taxed as income by the IRS.
How much do these costs matter? Let’s say you’re a single California resident with a $100,000 direct subsidized 10-year loan at a 4% APR, and you make $50,000 per year with a projected 5% annual salary bump.
On the standard repayment plan, you’d spend $121,494 total on principal and interest over 10 years. But on REPAYE, you’d spend $173,225 total—and you’d pay off your loan just a few months shy of the 25-year forgiveness mark.
Of course, your own income and loan details will make a difference in the outcome here, so find out how different repayment plans would affect you, check out our Student Loan Navigator tool, which can help personalize options to your situation.
2. The Surprise Costs (and Administrative Burden)
Under any income-driven repayment plan, you have to “recertify” your income and “family size” annually. Recertification can be a cumbersome process, and if you miss the deadline, which happens over 50% of the time, according to the Department of Education, things can get messy.
For one thing, if your payments are so low they don’t cover your monthly interest cost, the interest builds. Miss the recertification deadline, and you risk having accrued interest capitalized, or added to your loan’s principal.
Paying interest on your interest can cost you thousands more over the life of the loan.
Late recertification can also delay the date your loan is eligible to be forgiven, since you are automatically removed from the plan each time your certification lapses, and then put back on once you’ve completed the process.
Since time spent off the plan doesn’t count toward the 20-year forgiveness requirement, this could mean making some extra monthly payments before forgiveness can occur.
Additionally, if your income steadily increases and you’d like to switch to a standard plan to save money and be done with debt sooner, you may want to think twice. If you leave REPAYE all your accrued interest is capitalized, which means the longer you’ve been using the plan, the more the amount you owe has increased.
3. The Emotional Cost
Imagine for a moment that you do make it to the promised land of student loan forgiveness under an income-based repayment plan.
That means you’ve spent 20 years experiencing some level of financial hardship to make monthly payments toward a balance that might have grown exponentially with each passing year (if your payments were so low they didn’t effect the principal).
In other words, there’s an emotional tax attached, and that’s probably not what you pictured when you signed up.
The more common scenario (and frankly, the more desirable path) is that your financial picture will improve over time—you’ll get job offers, raises, and maybe even an inheritance or a bonus or two. And if that means becoming ineligible for eventual loan forgiveness, you’re probably going to be okay with the trade-off.
The Big Picture
Despite its downsides, an income-based repayment plan can be a useful tool for some borrowers. If you have a large amount of student loan debt, a low-to-modest salary, and, most importantly, don’t anticipate your income increasing much over the next couple of decades, you should give it serious consideration.
If, on the other hand, you expect your salary to moderately increase at some point, an income-driven plan could cost you more money in the long run.
The Main Income-Driven Repayment Options
If PAYE isn’t right for you, there are plenty of other options offered by the federal government or by private lenders. If you have federal loans, there are three other income-driven repayment options:
• Income-contingent repayment (ICR)<, which asks for generally 20% of your discretionary income. Your loans are eligible to be forgiven after 25 years. And just like the PAYE loan forgiveness option, you could be taxed on the amount that’s forgiven. • Revised Pay As You Earn (REPAYE), which takes generally 10% of your discretionary income. There is a forgiveness option after 20 years if you’re paying off your undergrad degree, or 25 years if you’re paying off undergrad and grad school loans. • Income-based repayment (IBR), which takes generally 10% to 15% of your discretionary income. Your loans are forgiven after 20-25 years, though you could get taxed on the amount that’s forgiven. If lowering your monthly loan payments is the goal, but you don't want the costs and headaches associated with REPAYE, consider refinancing your student loans at a lower interest rate instead.
Refinancing can decrease your payments and cut your total interest costs significantly. You can also shorten your payment term to save even more money, and be done with loans that much sooner.
For the borrower who bets on eventual loan forgiveness as a panacea for student loan woes, it’s important to take a hard look at the price of that journey. Because, in the end, loan forgiveness is never free. Get more information on forgiveness and other student loan strategies at SoFi’s student loan help center.
External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
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If you are a federal student loan borrower, you should consider all of your repayment opportunities including the opportunity to refinance your student loan debt at a lower APR or to extend your term to achieve a lower monthly payment. Please note that once you refinance federal student loans you will no longer be eligible for current or future flexible payment options available to federal loan borrowers, including but not limited to income-based repayment plans or extended repayment plans.
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