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If you've taken out student loans, you've likely encountered the term "discretionary income." But what does that mean and how does it impact you?
Discretionary income is the money you have leftover after paying for necessities like housing, groceries, everyday expenses and necessary bills. It's often used to calculate repayment of federal student loans, though not everyone makes enough money to have discretionary income. How you calculate it differs depending on whether you're doing it for your own budgeting purposes or if you have federal student loans, since the government has a standardized formula.
Discretionary Income Definition
When you receive a paycheck with taxes deducted, the remaining post-tax amount is called your disposable income.
Once you factor in how much you spend on necessary purchases—things like food, transportation, health care and bills—the amount left is called your discretionary income.
Think of it as the money you would use for fun stuff like vacations, gym memberships, spa services, hobbies, eating out and entertainment. It can also include optional savings, like saving for a house down payment or building up your emergency fund.
Discretionary Income vs. Disposable Income
Discretionary and disposable income sound alike, and they're similar concepts, but they have key differences.
- Disposable income is a general personal finance term that simply describes how much income you have left after taxes are paid. It doesn't account for money you have to spend on essentials.
- Discretionary income is a more specific term that's typically used in the world of federal student loans. It accounts not just for the money leftover after taxes but after you also deduct expenses you can't live without. This gives a more accurate picture of how much you have to spare after life's required costs, so it's used to help calculate payments for income-driven repayment plans for federal student loans.
When Is Discretionary Income Important?
While it can help with budgeting, knowing your discretionary income is important if you have federal student loans.
If you choose to be on an income-driven repayment plan for your federal student loans, your payment is based on a percentage of your discretionary income. Your family size is also factored in, since the goal is ensure you can pay your loans while still having enough income for your family's size. That could even mean no monthly payment.
Here's how much of your discretionary income is required as payment on your student loans under each income-driven repayment plan:
- SAVE plan (formerly Revised Pay As You Earn): Typically between 5 and 10%
- PAYE plan: Typically 10%
- Income-based repayment (IBR) plan: Typically 10% if you're a new borrower on or after July 1, 2014 (if you're not a new borrower on or after July 1, 2014, it may go up to 15%)
- Income-contingent repayment (ICR) plan: The lesser of 20% of discretionary income or what you'd pay with a fixed payment plan over 12 years, adjusted according to income
How to Calculate Discretionary Income
To calculate your discretionary income for your own budgeting or knowledge (not student loans; more on that below) look at your take-home pay each month. In other words, the money you receive from your employer after taxes and other deductions is the money you have to work with. If you're self-employed and receive pretax income, calculate your average earnings minus what you owe for taxes.
Next, subtract all of your necessary expenses. Think of all the required costs for everyday life that are needs rather than wants, such as:
- Mortgage or rent
- Utility bills, such as power, water and internet
- Health care
Don't count recurring payments that aren't technically necessary, such as streaming services or gym memberships. The amount left is your discretionary income.
To calculate this yourself, say your monthly take-home pay is $3,000. When you add up your necessary monthly expenses, they total $2,400. Subtract that from your take-home pay, and that indicates $600 in discretionary income each month.
Calculating Discretionary Income for Student Loans
Unfortunately, if you have federal student loans, it gets trickier: The government uses a different calculation for certain types of income-driven repayment plans. So if you have federal student loans, your discretionary income is based on a standardized formula rather than your actual amount. The goal is to ensure borrowers can actually afford their monthly payments.
For the first three plans listed above (SAVE, PAYE and IBR), the government calculates discretionary income as the difference between your annual income and 150% of the poverty guideline for your state and family size. For the last plan (ICR), it's the difference between your annual income and 100% of the poverty guideline.
This can get confusing, so let's use an example. Say you have a family of four and make $60,000 per year after taxes.
For 2023, the federal government indicates a family of four has a federal poverty guideline of $30,000 in the 48 contiguous states and Washington, D.C. Depending on the income-driven repayment plan you use, you'll need to either calculate 150% of that amount or 100%.
Let's say you have an IBR plan, which uses the 150% formula. Basic math shows that 150% of the poverty guideline of $30,000 is $45,000.
The government formula gets your discretionary income by subtracting that $45,000 figure from your annual income. If your annual income after taxes is $60,000, you subtract $45,000 from it. That leaves you with $15,000 as your estimated annual discretionary income, or $1,250 per month. The downside of this formula is it doesn't account for your true personal expenses, but it's how the government estimates it for purposes of ensuring income-driven student loan repayments are affordable.
The Bottom Line
Getting on an income-driven repayment plan for your federal student loans can lower your monthly payment, since it's based on what you can afford rather than a fixed amount. However, low payments and growing interest means it could take a long time to get out of debt (these plans can make you eligible for loan forgiveness programs, but it can take 10 to 25 years to qualify).
If you have a number of student loans, or you also have credit card debt, one option is to combine them into a debt consolidation loan. Some borrowers may find it easier to streamline debts into one monthly payment, and it's possible to nab better terms and lower interest rates. To explore your options, compare debt consolidation loans from Experian's partners.