Income-Driven Student Loan Repayment Plans Can Cost More

Income taxes on the amount forgiven and more interest may make regular repayment a better idea for some borrowers.

Education Arne Duncan announced that plans are moving forward to expand access to an income-driven repayment plan that caps federal student loan borrowers’ payments at 10 percent of their discretionary income.

He was talking about the newest proposed income-driven repayment plan, tentatively called Revised Pay As You Earn, or REPAYE. Under the proposal, all direct loans, Stafford loans and consolidation loans that don’t include parent PLUS loans would be eligible for the new plan, which would forgive any remaining balance after 20 years for undergraduate borrowers, among other benefits.

As with existing repayment plans, forgiveness would be taxed as income. The new plan would be an improvement for some borrowers, but others may find their current plan is a better fit for their circumstances.

The income-driven plans have been promoted and discussed quite a bit over the past few years to ensure that borrowers having difficulty making payments on their federal loans are aware these options exist. But these plans aren’t a good idea for everyone, and there are cases where these plans might not make sense.

Many borrowers beginning repayment are looking for the lowest payment they can get. When you’re just starting out, that lowest payment might be the only payment you can afford.

Seeking out the lowest payment you are allowed, however, can become a problem once your income increases. Remember, with federal student loans and most private loans, interest accrues daily off of the current balance. This means the longer you take to repay the loan, the more you’ll pay back in the long run.

When borrowers use one of the income-driven plans, they often think this risk is minimized due to what they assume will be loan forgiveness. The thought might be, “I must be paying less if I’m getting money forgiven.”

In many cases, however, you actually may be paying back more. Here’s an example:

A borrower has $ 45,000 in federal direct loans at a 4.5 percent interest rate. Let’s say the borrower has $ 20,000 in direct subsidized Stafford loans and $ 25,000 in direct unsubsidized Stafford loans. His or her first job out of college provides an adjusted gross income of $ 35,000. The borrower lives in Massachusetts, is not married and has no other dependents.

According to the Department of Education’s repayment calculator, which assumes a 5 percent income increase annually but no change in marital or dependency status, the various payment options make a huge impact on the bottom line of total amount paid. Note that REPAYE isn’t represented here, as it’s still in draft form.

As you can see, under income-based repayment and Pay As You Earn, the borrower does receive forgiveness of about $ 6,000; however, she will end up paying over $ 15,000 more over the life of the loan under this plan than she would have under a standard 10-year plan. If you consider that this $ 6,000 will likely be taxed as income, the benefit loses even more of its sparkle.

So should you stay away from the income-driven plans? Absolutely not. Just like other consumer debt, the goal with student loans should be to pay them back as quickly as possible to reduce interest, while keeping your other financial goals, such as retirement and emergency funds, in good standing.
It’s a good idea to get into the habit of reviewing your budget, including your student loan payment, on an annual basis to see if you’re still on the plan that’s best for you in the long term. The final version of the REPAYE rules are expected at the end of October, with implementation at some point a few months after that.

The Education Loan Interest Ranger will be sure to keep you updated as things progress. Just remember: That lowest payment may end up being the most expensive payment in the long run.

Source:http://www.usnews.com/education/blogs/student-loan-ranger/2015/07/15/income-driven-student-loan-repayment-plans-can-cost-more