If you graduated in May, your student loan grace period is quickly coming to an end. If you have tried to put your debt out of your mind – and I don’t blame you – getting the bill for the first loan payment can come as a shock.
If your salary looks downright paltry compared to what you owe, don’t panic. There may be some options for can help if you have federal loans.
Income-driven repayment (IDR) plans can make it easier for federal student loan borrowers to manage their debt. If your income is low compared to your student loan balance, your payments could be lowered through an IDR plan, based on factors such as income, family size, and current expenses.
But switching to IDR is a big decision with long-term consequences. Before applying, make sure you understand the different plans and how they each can affect how much you end up paying back. Doing your homework now will help prevent unwelcome surprises later on.
Types of income-driven repayment plans
Income-driven repayment plans can be confusing. There’s several different options, but many of them have very similar names. Here’s a breakdown of each plan and their terms.
Federal student loan borrowers have four income-driven repayment plans to choose from:
- Income-Based Repayment (IBR): Your payments are spread over the course of 20 years in order to help reduce your monthly bill. Payments are also capped at 10 percent of your discretionary income. Almost all federal loans are eligible for IBR.
- Income-Contingent Repayment (ICR): There are two possibilities under ICR: payments are either 20 percent of your discretionary income or what you would pay on a 12-year fixed-payment period, whichever would be less.
- Pay As You Earn (PAYE): Under PAYE, your repayment term is extended to 20 years and payments are capped at 10 percent of your income. To be eligible for PAYE, you have to be a new borrower as of October 2007 and payments must be less than they would on the 10-year Standard Repayment Plan.
- Revised Pay As You Earn (REPAYE): Payments under REPAYE are restricted to 10 percent of your discretionary income. But it’s important to note that under REPAYE, your payment amounts can exceed what they would be under the Standard Repayment Plan as your income increases. If you took out graduate or professional loans, your repayment term can be as long as 25 years.
Under each of these plans, any remaining debt is forgiven at the end of the repayment period. However, you are still taxed on the forgiven amount that same year.
You also need to reapply for your IDR plan each year. To do so, you will need to provide information on your income, family size, expenses, and more. The plans you are eligible for depend on your loan types and financial situation.
Benefits of income-driven repayment
After graduation, many young professionals struggle to manage their expenses and keep up with their loan payments on smaller, entry-level salaries. IDR can make payments more manageable and prevent you from defaulting on your loans.
IDR also frees up more money in your monthly budget. That wiggle room can allow you to more comfortably afford other important expenses like rent and groceries.
Though it’s considered taxable income, having the rest of your loan balance forgiven (assuming you have any debt left) can also be welcome relief, especially if you borrowed a significant amount.
Finally, because you need to apply each year for IDR, what you pay is dependent on your situation. If you get laid off and end up taking a lower-paying job, your monthly payment will go down accordingly.
While income-driven repayment plans can open up some much-needed cash flow, they do have consequences that can impact your finances over the long-term.
When you switch to IDR, your repayment term is lengthened from 10 years to 20 or more. While your payments shrink, the interest rate stays the same. The longer repayment term means you pay back much more in interest than you would under the Standard Repayment Plan.
And while many people are excited to have their loan balance forgiven after 20 years of payments, many do not realize that the forgiven amount is taxable. They get hit with a surprise tax bill when it’s time to file their returns, costing them hundreds or even thousands of dollars.
Think it through before making a decision
IDR plans offer a valuable alternative for people struggling to manage their student loan debt. They can make your payments more manageable and allow you to have more money to spend on other essentials. When you are working a low-paying job, IDRs can be a huge help.
But switching to an IDR is a big decision. It’s important to weigh the pros and cons as they relate to your specific situation. It may be that it makes more sense to scrimp now and stay on the Standard Repayment Plan to avoid paying extra interest.
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