Last week we reported on new data showing that more student borrowers could benefit from federal income-based repayment programs than currently use them, partly because the programs aren’t well publicized. The data was affirmed by our readers, who seem keen to learn more. Here are the answers to four commonly asked questions about how those programs work—and whom they do (and don’t) benefit.
What, exactly, are we talking about here?
There are actually four different options that tie what borrowers pay to their income. The programs have confusingly similar names and vary in eligibility and benefits. Let’s focus on the two main programs, called Income-Based Repayment (IBR) and Pay As You Earn Repayment (PAYE).
What’s so good about them?
These programs make student loans more affordable by capping monthly payments to a certain percentage of a borrower’s discretionary income. Then, after a designated period of time, the various repayment plans erase the remaining principal balance on a loan. IBR caps payments at 15 percent of a borrower’s income and forgives the remaining balance after 25 years. The more-generous PAYE is available only to more recent borrowers. It caps payments to 10 percent of a borrower’s discretionary income and forgives the outstanding balance on the loan after 20 years.
What’s not to like?
Two big questions loom over the benefits of this program. First, the amount of principal that is forgiven after 20 or 25 years is treated as income, which means it’s taxable. (The one exception is in a program designed to encourage students to take public service jobs. In that case, the principal is forgiven, tax free, after 10 years.) The other big question mark is that if a borrower’s reduced monthly payments don’t even cover the interest that accrues—not unlikely for someone with a lot of debt and very little income—that unpaid interest can be tacked on to the principal on the loan. This happens after the first three years of making payments under IBR or PAYE. It’s called “negative amortization” and generally should be avoided.
Where do I sign up?
Are you sure you want to? These programs all increase the amount of interest owed because they stretch the term from the standard 10-year window. Borrowers who can afford the standard 10-year repayment plan will save money; this is also why the National Consumer Law Center and others don’t encourage every borrower to use these programs. One exception may be the particularly big windfall PAYE has for graduate students in such high-cost programs as law and business school. The benefit for future lawyers and consultants is potentially so large that some people have suggested closing the grad school loophole and directing the resources toward lower-income undergrads or others who may need it more.
Given the complexity of these programs, there are plenty of calls to simplify the system. In the meantime, Finaid.org has calculators to estimate scenarios under both IBR and PAYE, and the New America Foundation has a series of helpful sample scenarios in its report on the programs.