Income-Based Student Loan Repayment May Leave You Deeper In Debt
Unless you spend most of your time with your head stuck in the sand, you probably know all about how bad the student loan crisis has gotten. Grads are paying more than ever for a college education and they're leaving school weighed down by thousands of dollars in debt.
In an effort to offer some relief to struggling students, the federal government has rolled out several income-driven repayment options. These plans let you lower your monthly payment according to what you earn and they allow you more time to repay what you owe. When you're fresh out of school and you're not raking in a huge salary, an income-driven plan may be a better fit for your budget but there are some strings attached. In fact, income-based student loan repayment may actually cost you more money in the long run.
How it works
How your plan works varies according to which option you choose. Income-based repayment or IBR caps your monthly payment at either 10 or 15 percent of your discretionary income, depending on when you took out your loans. Your payments can change if your income fluctuates and you have up to 25 years to pay off your debt. After that, any remaining balance is automatically forgiven.
The Pay As You Earn option limits what you have to pay each month to 10 percent of your discretionary income. Payments can go up or down in conjunction with your earnings and the repayment period is set at 20 years. Like IBR, the rest of the loan is forgiven once you reach the time limit and you have to have a partial financial hardship to qualify.
Finally, there are the income-contingent and income-sensitive plans. With income-contingent repayment, your payments are calculated based on your annual adjusted gross income, household size and the amount you owe. The repayment period is extended to 25 years, after which the remainder of the debt is written off. Income-sensitive repayment uses your annual income into account to determine your payments but you only have 10 years to pay them off and loan forgiveness doesn't apply.
Why it can make your student debt more expensive
The obvious advantage of income-based student loan repayment is that it offers some flexibility for borrowers who are having trouble keeping up with their payments but don't want to go into default. The problem is that the longer you stay on an income-driven plan, the more money you're going to end up throwing away on interest. Here's an example to show you what we're talking about.
Let's say you owe $30,000, which is right around the average amount students graduated with in 2012. Your interest rate is 4.66 percent, you're making $30,000 a year and you're single. If you go with the standard 10-year repayment plan, your monthly payments would be $317 and you'd pay just over $7,600 in interest.
Now, let's assume you opt for the IBR plan. Your payments fluctuate between $176 and $317 as your income changes but you manage to get the debt paid off in 15 years. The total you've paid in interest? Almost $13,500, nearly double what you would have paid under the standard plan. When you run the numbers, it becomes apparent that income-based payments come with a high price tag.
Tax implications of income-based student loan repayment
Not only could you end up paying far more for your loans in interest, there's also the possibility that you'll get hit with a big tax bill once your repayment period ends. That's because the IRS considers forgiven debt to be taxable income so if you borrowed a substantial amount and didn't make much of a dent in the balance, all that money has to be reported when you file. If it pushes you into a higher tax bracket, it can substantially increase your tax liability.
When you should (and shouldn't) use it
If you're in a serious financial pinch and you want to avoid the consequences of default at all costs, then you should look at whether income-based student loan repayment is a feasible option. Before you go about applying, however, you should come up with a plan for limiting the amount of time you have to use it so you don't sink too much money into the interest.
For instance, it doesn't make sense to stay on an income-based plan if you get a raise that offers you a little more breathing room, even if you still qualify for the program. If you receive a windfall that allows you to take out a big chunk of your student debt all at once, then making the switch back to the standard repayment plan can cut down on your interest costs.
Finally, you want to make sure that you're not eligible for any kind of forgiveness program that would knock out some of your loans before you agree to income-based repayment.
Have you successfully taken advantage of IBR after graduation? Comment below and let us know!