What Is Income-Driven Repayment?

young couple sitting on the floor going over finances

It's not uncommon for students to invest a lot of money into their education, only to be disappointed when their high-paying dream job fails to materialize.

For example, an Experian survey of recent soon-to-be-graduates found that 40 percent rate their current financial security as poor or fair, and only 16 percent of soon-to-be graduates already have a job lined up.

Others seek an expensive education without fully considering the costs of repaying their student loans. In either case, many college graduates will have trouble paying back their student loans when they fail to earn as much as they had hoped. For example, the Wall Street Journal reported last year that 43% of the 22 million Americans with federal student loans weren't making payments. The overall total outstanding student loan debt was $1.49 trillion in the fourth quarter, 2016. Thankfully, there are income-driven plans that allow you to repay your federal student loans based on how much you currently earn.

How Income-Driven Repayment Plans Work

An income-driven repayment plan allows you to set your monthly student loan payment to an amount that you can afford based on how much you earn. You can choose from four different types of federal student aid income-driven repayment plans offered by the Department of Education. After you've chose a plan, you must then reapply every year based on your current income. After 20 or 25 years of repayment on an income-driven plan, any remaining balance is forgiven.

Qualifying for an Income-Based Repayment Plan

To qualify to refinance your federal student loans using an income-driven repayment plan, you have to meet two different criteria. First, you must have a qualifying federal student loan. There are over a dozen types of federal student loans that may be eligible for a type of income-driven repayment plan, and you can consult this chart to find out if the type of loan you have qualifies.

Second, your current federal loan payment must be greater than 10% of your discretionary income for loans received after July 1, 2014, or 15% for loans taken out before then. Your discretionary income is defined as any income you earn beyond 150% of the Federal Poverty Level, which will vary based on your household's size.

For example, for 2017, the Federal Poverty Level for single individuals is $12,060, so any income you earned beyond $18,090 would count as discretionary. If you were single with no dependents, and you earned $30,000, you would only have $11,910 of discretionary income. Therefore, a payment of of just $100 a month would exceed 10% of your discretionary income, qualifying you for many income-driven repayment plans. You can use the U.S. Department of Education's IBR calculator to figure out what your discretionary income is, and if you would benefit from the from an income-based repayment plan.

How to Apply

Once you've chosen an income-driven repayment plan, you can fill out and submit an Income-Driven Repayment Plan Request online or with a paper form from your loan servicer. You must submit a separate form for each loan servicer you have. If you filed federal income taxes over the last two years and your current income is similar to what you reported, then you will use your adjusted gross income on these forms, which is the total amount of money you've earned, minus allowable tax deductions. But if you haven't filed two years of tax returns yet, or your income has changed significantly, then you must submit other documentation of your income such as a pay stub. Either way, you should receive an answer to your application within a few weeks.

You Must Reapply Every Year

Since your income could change every year, income-driven repayment plans require that you fill out a new form each year to prove that you still qualify. This process works much like the original application, and can be done online or using a paper form. If you fail to re-certify each year, your loan may go back to a Standard Repayment Plan, with a higher monthly payment. This can be especially shocking if you've authorized automatic payments, and aren't expecting a much larger withdrawal from your bank account.

Qualifying for Loan Forgiveness

One of the advantages of an income-driven repayment plan is that the remaining balance will eventually be forgiven if not paid off after 25 years, or 20 year for those who choose Pay As You Earn (PAYE), one of the four types of income-driven repayment plans available. Also, if you have a subsidized loan and your monthly income-driven payment is less than the interest that accrues, the government will pay the difference for the first three years that you are repaying through the program. For example, if your monthly income-driven, payment is just $100, and the interest on your loan is $110, the government would actually pay $10 a month to ensure that your principal balance won't increase during the first three years.

The Four Types of Income-Driven Repayment Options:

  1. Income-Based Repayment (IBR). This plan caps payments at 10 percent of your discretionary income if you received your loan before July 1, 2014, with forgiveness after 20 years. For those who receive their loan afterwards, the maximum payment is 15 percent of your income with forgiveness after 25 years.
  1. Pay As You Earn (PAYE). This plan can help you reduce your monthly payments to a maximum of 10 percent of your discretionary income, and offers forgiveness after 20 years of repayment. To qualify, you must have received your loan on or after October 1, 2007. You must also have borrowed a Direct Loan or a Direct Consolidation Loan after October 1, 2011. Finally, you also need to demonstrate partial financial hardship to qualify.
  1. Revised Pay As You Earn (REPAYE). This plan caps your monthly payments at 10 percent of your discretionary income. You can choose the REPAYE option even even if your monthly payments are higher than they would be on a Standard 10-year plan. This option is available to borrowers with any Direct Loans, Stafford Loans, and Graduate PLUS borrowers, as well as other federal student loans that have been consolidated into Direct Loans.
  1. Income-Contingent Repayment (ICR). This plan calculates your monthly payments based on 20 percent of your discretionary income, but there are no income requirements to qualify for this type of plan. Yet it still offers loan forgiveness after 25 years. Therefore, your monthly payment could be higher or lower than the Standard Repayment Plan.

Choosing an Income-Driven Repayment Plan

Choosing the right income-driven repayment plan for your needs can be confusing, so it makes sense to get the help of your loan servicer. Your loan servicer can help you to understand which of the four payment plans you qualify for, and what the terms will be. Keep in mind, defaulting on a student loan affects your credit score, so make sure the monthly payment fits into your budget.

Next, you'll want to evaluate your options, taking into account the total length of the repayment period. For example, you might not want to have too low of a loan repayment amount, which can extend your repayment period, forcing you to incur more interest charges. You'll also want to consider the loan forgiveness period.

Bottom Line

It can be difficult to pay back your student loans, especially if you have a modest income. By examining the different income-driven repayment options available for you student loans, you can make your monthly payments affordable, and even have some of your loan eventually forgiven.

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