Student loan payments make up an increasingly large percentage of 20-somethings’ monthly expenses and are one of the biggest reasons it can seem so difficult to get ahead—even with a decent job.
And student loan payments are one expense you definitely can’t skip. Defaulting on federal student loans won’t just ruin your credit, it may lead to wage garnishment and a loss of future federal benefits, including Social Security.
If you have federal loans, however, there are a few relief options you can consider and one of those is switching to an income-driven repayment plan.
Income-driven repayment plans reduce your monthly student loan payments, making them more affordable. As the name suggests, payments are based on how much you earn each month. With an income-driven repayment plan, your monthly payment is usually 10 to 20 percent of your discretionary income—that is, your income after taxes.
This means you don’t have to worry about your monthly loan payment taking up a significant amount of your income, such as 40 or 50 percent.
While switching to an income-driven repayment plan may sound great, there are certain rules, eligibility criteria, and pitfalls that you’ll need to consider.
1. There are three options
If the idea of having an income-driven student loan repayment plan has piqued your interest, you must understand that there are different types of plans that you will need to choose from.
The most common, is an income-based repayment plan (IBR) which generally doesn’t allow your student loan payment to exceed 10 percent of your income (as long as you took out loans after July 1, 2014) with a 20- or 25-year term . If you’ve taken out loans before July 1, 2014, you can expect your payment to be 15 percent (or less) of your discretionary income, but it will never exceed what you would pay with a 10-year standard repayment plan.
With the pay-as-you-earn plan (REPAY), the idea is that your required monthly payments will start out low while your income is low and they will steadily increase over time as your income increases and you obtain higher-paying jobs. Your payment may also be based on your family size. The general repayment term for this plan is 20 years.
The income-contingent repayment plan (ICR) will allow your student loan payment to be less than 20 percent of your after-tax income for a 25-year term. This plan is ideal for individuals who intend to pursue jobs with lower paying salaries, including public service careers.
2. You have to apply
If you are having trouble making your student loan payments each month on your federal loans, you can not just ask your loan provider to switch to an income-driven plan without applying first.
Each plan has slightly different eligibility requirements, so once you carefully research each plan to determine which one works best for you, don’t forget to check the specific eligibility requirements and discuss it with your loan servicer before applying.
You can go to StudentAid.ed.gov to complete an application. The application can take a few weeks to process since your loan servicer needs to obtain documentation to confirm your income and family size.
3. You will pay more in the long-run
While switching to an income-driven repayment plan will lower your minimum payment each month, you will most likely pay more in total interest because it’s going to take you longer to pay off the loan.
To go from a 10-year term with the standard repayment plan to a 20-year term with an income-based repayment plan can cause you to pay quite a bit in interest depending on your interest rate and how much you owe.
That being said, income-driven repayment plans may be a better temporary option to help you manage your debt repayment while your income is low or if you are going through a financial hardship.
Remember though, you can always make extra payments on your federal student loans penalty-free in order to reduce the amount of interest you have to pay.
4. After 20 or 25 years, your balance will be forgiven, but…
If you choose an income-driven repayment plan and do not pay off your loan after a term of either 20 or 25 years (depending on the plan you select and other criteria), your remaining balance will be forgiven.
The downside to student loan forgiveness (and it’s a big one) is that the IRS considers a forgiven student loan balance to be taxable income. For example, if you have a $10,000 student loan balance forgiven, you would have to pay federal income taxes on that $10,000 as if you earned it. Hopefully, any remaining balance after 20 or 25 years will be small, but if you’re banking on student loan forgiveness of any kind, do not overlook this unfortunate reality!
5. You must renew your plan each year
Having an income-driven repayment plan requires a little maintenance. If you would like to keep your plan, you must renew it annually and on time. If you don’t, your payments could revert back to your original loan agreement and possibly increase. During the renewal period, you must be very organized and alert and open all of your mail, then check back with your servicer to confirm that your income-driven repayment plan has been renewed.
If your federal student loan payments are hard to manage, then switching to an income-driven repayment plan is a viable option—as long as the pros outweigh the cons. However, your interest rate may be the cause for your high minimum payment, and, in that case, you may want to look into student loan consolidation, which may lead to a lower interest rate, which will lead to a lower monthly payment. Income-based repayment plans spread your loan out over a longer term; they do not necessarily lower your interest rate.
The end goal should always be to properly manage your loan payments so you can make consistent progress toward getting rid of them for good.