With student loan debt is rising and recent grad employment rates / wages falling, the Obama administration crafted repayment plans to help borrowers manage their student loan debt responsibly and provide relief to borrowers who struggle the most. The U.S. Department of Education launched a “pay as you earn” (PAYE) program, one of several repayment options that allow borrowers to base their payments in whole or in part on income.
What is the pay-as-you-earn student loan repayment program?
In a nutshell, if you are unemployed or earn very little money, you can make lower payments (as low as zero). Unlike a traditional deferment or forbearance, in which interest continues to accrue and unpaid interest is added to the principle balance, the pay-as-you-earn program sets a limit on interest capitalization so long as you meet the hardship requirements. And the government will pay the interest that accrues on subsidized loans for the first three years of your repayment program if your payment is too low to cover it. Even when your financial situation improves, your required payment will never be more than the 10-year standard repayment amount. After you make qualifying payments for 20 years, any unpaid balance is forgiven.
Under the PAYE program, your payment is based on your discretionary income. That number is calculated like this:
Find your adjusted gross income (AGI), which is your total income minus any reductions (such as personal exemptions and itemized deductions). Your AGI can be found on last year’s tax return – line 27 on Form 1040; line 21 on Form 1040A; line 4 on Form 1040EZ. Subtract your AGI from 150 percent of the federal poverty level for your family size. The difference is your discretionary income. (Click here for the federal poverty guidelines.) Your loan payment is equal to 10 percent of your discretionary income divided by 12. See this document for maximum payment amounts for different income levels and family sizes.
Here’s an example:
Mary is single and had an adjusted gross income in 2012 of $19,000. She deducts 150 percent of the one-person household federal poverty guideline, or $16,755. The difference is $2,245 – that’s her discretionary income. Her maximum payment under the pay-as-you-earn program is one twelfth of $224.50, or $18.71 (10 percent of her discretionary income divided by 12). Mary’s student loans total $50,000 and the standard 10-year repayment amount is nearly $500 per month. She will benefit significantly from participating in the program.
If Mary’s AGI drops to $15,000, her payment goes down to zero. If her income goes up to $30,000, her payment rises to $110.
Who is eligible?
To take advantage of the program, borrowers must have loans that were taken out after October 1, 2007, and must have received at least one disbursement after October 1, 2011. Also, the standard 10-year repayment amount must exceed 10 percent of the borrower’s discretionary income.
- Payments never exceed that of the borrower’s 10-year standard repayment plan, and can be as low as zero
- After 25 years, the unpaid balance is forgiven. Some borrowers who choose to enter public service will see their balance forgiven in only 10 years
- The government pays unpaid accrued interest on Direct Subsidized Loans and on the subsidized portion of Direct Consolidation Loans for three years if your payment amount does not cover the interest. Also, interest capitalization is limited – even in deferment and forbearance – for as long as the borrower meets the hardship requirements.
What are the downsides?
- Eligibility and payment caps are tied to household income, not individual income. So while a single borrower with an entry level job could benefit greatly from the pay-as-you-earn repayment plan, a married borrower, whose spouse earns around the same income but has no outstanding student loans, might not benefit at all.
- The borrower may have to pay income tax on the forgiven portion of the loan
- Borrowers who participate will pay more interest overall, due to the lengthening of the loan repayment period.
- Participants must provide qualifying documentation annually
- This program applies to federal loans only (not private loans), and specifically Federal Direct Loans, although other student loans are taken into account when determining hardship. For example, Federal Family Education Loans (FFEL) loans are not eligible for this plan, but are considered when eligibility is determined. FFELs are eligible for Income-Based Repayment plans, another new program.
Other student loan repayment options
Extended repayment plans (up to 25 years) and graduated repayment plans, in which payments start low but increase every two years, are also available to borrowers who meet certain criteria. Income-Based Repayment (IBR) plans are available, and are based on 15 percent of your discretionary income.
Although FFELs are not eligible for this program, borrowers can consolidate FFELs into the Direct Loan program in order to qualify (assuming they were not taken out prior to October 1, 2007).
For all borrowers, the best deal is still the standard 10-year repayment plan, which will incur the least amount of interest and thus cost the borrower the least amount of money over the life of the loan.
Harry Langenberg is the Co-founder and Managing Partner of Optima Tax Relief. He has over 10 years of financial services experience, including investment banking for technology-based firms at Merrill Lynch & Co. in San Francisco, CA.