Mortgages

How Does Income Driven Repayment Plan Work

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 18 minute read

New York Federal Reserve Bank statistics from the first quarter of 2021 shows that student loans have surpassed both credit card and auto loan debt to become the second largest source of consumer debt, behind only mortgages. 

As a result, a lot of people in the United States are finding it impossible to pay off their debts. CNBC reports that annually, more than one million students are in arrears on their student loans. Furthermore, Brookings, a non-profit organization that studies public affairs, projects that as much as 40% of all borrowers will fail by the year 2023.

The repercussions of student loan default can be severe, including the withholding of income and the destruction of credit, making it difficult, if not impossible, to obtain additional financing, whether federal or private.

Federal student loan borrowers, to their good fortune, have a number of options for managing their repayment obligations, including as forbearance and deferment, consolidation, and income-driven repayment (IDR) programs. 

It is possible to reduce your monthly federal student loan payment by enrolling in one of the available IDR plans if the amount you owe each month is more than you earn or if it is preventing you from affording essential living expenses.

The Operation of Income-Driven Repayment Plans

Loans from the federal government have a default 10-year repayment period. However, the regular repayment plan may be unaffordable if you have a large debt load, a low income, or both.

Paying more than 10% of your discretionary income meets the IRS criteria of partial financial hardship. Because of that, your regular payments can be lowered.

This is where IDR strategies come in handy. IDR plans adjust monthly payments based on a borrower’s income and family size rather than the loan’s principal balance or the duration of the repayment period. 

Better still, if you make all your payments on time and still owe money after the agreed upon time period is up, the debt may be cancelled. These programs are useful for recent college grads who are either unemployed, underemployed, or working in low-paying fields. 

For these grads, IDR is the difference between being able to manage their student loan debt and falling into default because their monthly payments are more than their paychecks.

IDR Plans Method for Determining Your Discretionary Income

Payments under IDR plans are based on a predetermined percentage of after-tax income. Your discretionary income is the sum that results after subtracting the percentage of the federal poverty line that applies to your family size and state from your adjusted gross income (AGI).

Your AGI is your yearly (pretax) income less specific deductions like those for loans and alimony and retirement savings. Check with the United States Department of Health and Human Services to learn the current poverty guidelines for your household size.

Following these rules, certain borrowers may be offered an IDR plan with no monthly payment at all. That’s a major boon for those struggling with low salaries or unemployment. 

Instead of delay or forbearance, they can continue paying into their IDR plan. As well as the fact that it serves two important purposes, that choice is strongly recommended. Time spent in forbearance or deferment does not count toward the forgiveness clock, unless it is a hardship deferment, which is capped at three years. 

But the amount of needed payments does include any payments that are zero dollars. Additionally, once the deferment or forbearance ends, any interest that has accrued on your unsubsidized loans at that time will be capitalized. 

When interest is capitalized, it is added to the loan’s main balance by the servicer. If that happens, you’ll have to fork over more interest on top of the interest already accrued on the increased debt.

On the other hand, with IDR, if your monthly payment is less than the interest that accrues on your loans, the difference between the two will not be capitalized until you quit the program or reach an income cap. The only exception to this rule is the income-contingent repayment plan (which is a form of IDR). Interest is compounded each year and then capitalized.

Forgiveness of Student Loans

If you have any of your student loans in an IDR program, you can get those loans discharged. If you make all the payments on your IDR plan and there is still a balance when your term is up, the government forgives the rest of the debt and you don’t have to pay it back. 

For illustration, say your plan calls for 240 installments. This won’t reduce the $30,000 balance of your loan in the least. You don’t have to fork off the final $30,000 if you qualify for loan forgiveness.

Basic loan forgiveness is offered to all borrowers in an IDR program, whereas public service loan forgiveness is available to individuals who have demonstrated a commitment to public service (PSLF).

Forgiveness of Public Service Loans

Borrowers with as low as 120 qualified IDR payments are eligible for full debt forgiveness through the PSLF program. Borrowers who are employed full-time by a government or nonprofit organization are considered to be in good standing and are therefore eligible to borrow. 

Doctors in public health, lawyers practicing public law, and educators in public schools are just a few examples of the types of people that engage in public service. This definition extends to nearly everyone who works for a local, state, or federal government agency. 

Any group that meets the requirements of Internal Revenue Code Section 501(c)(3) can be considered a nonprofit. This group does not consist of labor unions, political parties, or private companies hired by the government to perform tasks for a fee.

Teachers, who need a lot of schooling but make a decent living, may profit from PSLF. It’s very tough to obtain, unfortunately. Insider claims that despite the program’s long history of turning down debtors who were under the impression that they were eligible for debt cancellation, that rate remains at 98%.

However, there is a chance for improvement. The Biden administration promised in May 2021 to reevaluate and improve all federal student loan repayment, cancellation, discharge, and forgiveness programs, including public service loan forgiveness, for the benefit of borrowers.

In order to increase your chances of qualifying for PSLF, the ED suggests submitting an employment certification form on an annual basis and if you make a work change. The PSLF application must be submitted after 120 eligible payments have been made.

Forgiveness of IDR Loans

There are a variety of additional IDR forgiveness programs, but they all require borrowers to make a minimum number of payments (often between 240 and 300) before their loan sums are forgiven. 

There is no formal application process for student loan forgiveness at this time because the initiative is quite young and no borrowers have met the requirements.

The ED says your loan servicer will keep tabs on your qualifying payments and provide you a reminder before your forgiveness date rolls around. No one can say for sure if there will be a standardized application process or if it will be done automatically. 

With any luck, the procedure will become uniform as the program matures and borrowers begin to take advantage of the benefit.

Effects of Forgiveness

One of the greatest benefits of IDR is debt forgiveness, which is especially helpful for people who have taken on excessive debt in relation to their income. However, ordinary student loan forgiveness has both benefits and drawbacks. 

First, while the prospect of having a loan forgiven may seem appealing, the average borrower pays off their IDR in 20 to 25 years and has no outstanding sum to forgive.

Additionally, if your debt is cancelled by the government, the amount written off will be considered taxable income by the Internal Revenue Service. 

If you don’t have the money to pay your taxes in full and still have a sizable sum on your student loans, you’ll have to make a number of extra payments, this time to the Internal Revenue Service (IRS), long after you expected to be done with your loan repayments.

Changes to this policy regarding student loans were made official by the American Rescue Plan Act of 2021, which was signed into law by President Joe Biden on March 11, 2021. 

Borrowers who have had their student loan balances discharged are exempt from income tax on the forgiven amount of their loan until the end of 2025 per Section 9675.

Most borrowers already registered in or considering enrolling in IDR will not benefit from that. Although the National Consumer Law Center notes that income-based repayment began in 1994, the first borrowers to become eligible for forgiveness did not do so until 2019. 

CNBC reports, however, that some industry watchers see this shift as permanent. Recall that PSLF debt cancellations are never subject to taxation.

Which Loans Qualify for IDR?

Under most IDR plans, you can only make payments on government direct loans. However, merging your student loans with a federal direct consolidation loan may make you eligible for these IDR programs if you have an older federal family education loan (FFEL), which includes Stafford loans or a federal Perkins loan, both of which have been terminated.

However, it’s important to remember that not every borrower would benefit from consolidation. Consolidating a federal Perkins loan with a direct consolidation loan, for instance, would prevent the borrower from qualifying for any loan discharge or forgiveness programs associated with the original Perkins loan. 

In addition, most IDR programs will no longer consider a consolidated debt that includes a parent PLUS loan to be eligible for forgiveness. Banks and other private lenders often provide their own repayment plans. However, they can’t take advantage of any federal loan forgiveness programs.

4 Different Income-Driven Repayment Strategies

In order to help students cope with their federal student loan debt, four IDR options are available. Every one of them has installment plans that scale with your monthly income and family size. 

However, each program has its own eligibility requirements, payment calculation method, and number of required installments before loan forgiveness is granted.

If you and your spouse file a combined tax return, their income may be included in some of your computations. To determine whether filing jointly or separately will yield greater financial benefits, married couples should talk to a tax expert.

Every IDR strategy is different, therefore it doesn’t matter if you’re married or single. Selecting the optimal plan is something your loan servicer may assist you with.

However, it is crucial that you learn about the characteristics, benefits, and drawbacks of each IDR type:

1. Income-Based Repayment Plan

The income-based repayment plan (IBR) is the most common type of IDR, but it is also the most difficult to understand. Borrowers with older loans may have to set aside a larger portion of their monthly income for loan payments because their repayment terms are longer. 

However, the payment cap in this IDR plan is more generous than in others.

  • Monthly Payment Amount. 15% of Disposable Income for New Borrowers Prior to July 1, 2014, and 10% for Borrowers After that Date. A zero dollar payment is necessary if the amount you owe is $5 or less. Pay $10 if the amount you owe is greater than $5 but less than $10. Your monthly payment will be adjusted proportionately if your spouse has student loan debt.
  • Calculating Discretionary Income for IBR involves subtracting your Adjusted Gross Income (AGI) from 150% of the federal poverty line for your family size and state of residence. If you’re filing your taxes as a married couple, your loan servicer will factor in your spouse’s income. If you’re filing your taxes as a single person or a divorced person, it’s not included.
  • As long as you continue in IBR, your payment will never exceed what you would have to pay under the conventional 10-year repayment plan, even if your income doubles. For up to three years, the federal government will cover the whole interest cost of your subsidized loans, including the subsidized part of a direct consolidation loan, if your monthly payments are lower than the interest that accrues on your loans. On unsubsidized loans, it does not pay the interest.
  • When a borrower’s monthly payments are no longer limited by their ability to make them in light of their income, as would be the case if the borrower’s income had increased to the point where the payment cap had been reached, the servicer capitalizes the interest.
  • If you took out a student loan before July 1, 2014, you have 25 years to pay it back, spread out across 300 payments. If you became a borrower on or after July 1, 2014, you will have 20 years to make 240 payments.
  • Eligibility. You must demonstrate partial economic hardship in accordance with IBR’s guidelines in order to qualify. If you’re looking at a 10-year repayment plan, the annual payment amount must be higher than 15% of your disposable income. Your loan servicer will factor in the amount of your spouse’s student loan debt if you file your taxes as a married couple. Only parent PLUS loans are not eligible for IBR.
  • Forgiveness. If you started making payments on your loan before July 1, 2014, the remaining balance will be forgiven after 20 years; if you started after July 1, 2014, the remaining balance will be forgiven after 25 years.

2. Plan for Repayment Based on Earnings

If you are eligible, the pay-as-you-earn (PAYE) plan is the most advantageous way to repay your student loans. It has various advantages over IBR, such as a shorter repayment period and lower monthly payment, depending on when the loans were taken out. 

Another benefit is that any interest that is capitalized cannot exceed 10% of the loan’s principal sum at the time of enrollment.

  • Monthly Payment Amount. 10% of Disposable Income, Never More Than What Would Be Required Under the Standard 10-Year Repayment Plan. Unless the total is more than $5, you will not be charged. Payment of $10 is required if the total is greater than $5 but less than $10. A married person’s monthly payment is recalculated based on their spouse’s student loan debt load.
  • You can expect your servicer to determine your discretionary income for PAYE by subtracting your adjusted gross income (AGI) from 150% of the poverty limit in your state. Incorporate your spouse’s income if you file jointly as a married couple. If you’re filing individually, they won’t count it.
  • Similar to income-based repayment (IBR), the maximum amount you’ll have to pay back in any given year is capped at the amount that would be required under a conventional 10-year repayment plan. If your monthly payments are less than the interest accruing on your loans, the federal government will cover the difference for up to three years. The program does not pay the interest on federally unsubsidized student loans.
  • If your income has increased to the point where your monthly payment would exceed the limit set by your servicer, the interest on your loan would be capitalized. However, your total capitalized interest cannot be more than 10% of the principal amount borrowed.
  • 20 years and 240 installments is the repayment term. If you’re married and filing jointly and either you or your spouse has student loan debt, then both of your loans will be counted toward the 10% discretionary income threshold needed to qualify for this plan’s partial financial hardship provisions. Another requirement is that you have paid off any direct loans or FFELs that were originated prior to September 30, 2007. One of your loans must better have been taken out after September 30th, 2011.
  • Except for PLUS loans taken out by parents, all federal direct loans are eligible for PAYE. If you have a remaining loan balance after 20 years of payments and you remain an active participant, the balance will be forgiven.

3. Revisions to the Pay-As-You-Earn Repayment Schedule

If you don’t qualify for a reduced payment plan due to financial hardship under PAYE or IBR, you may still be eligible for an IDR plan. Any individual with a direct federal loan can enroll in the revised pay-as-you-earn (REPAYE) plan regardless of their financial situation. 

The interest rate and length of time you have to pay it back also have nothing to do with when you took out the loan. The biggest advantages of REPAYE are the government loan interest subsidies and the lack of any interest capitalization.

Of course, REPAYE isn’t without its flaws. To begin with, there is no maximum amount that can be paid out. The amount you owe each month is determined by your income, even if that means making larger payments than you would under a typical 10-year repayment plan.

Also, graduate students have a longer period of time to repay their loans before they become eligible for forgiveness. This is a serious problem because graduate student borrowers are among the most financially vulnerable borrowers. 

Most people with six-figure student loan debt used the funds to finance graduate school, according to the Pew Research Center.

  • The minimum required payment every month is 10% of your disposable income. If the total amount due is less than $5, you owe nothing. Plus, if the repayment amount is over $5 but under $10, the full $10 is due. If your spouse has any outstanding student loan debt, your payment will be modified accordingly.
  • A person’s discretionary income is calculated by subtracting their adjusted gross income (AGI) from 150% of their state’s poverty level. It doesn’t matter if you and your spouse file jointly or separately; both of your incomes will be counted. However, your servicer won’t take into account your spouse’s income if you’re divorced or legally separated.
  • Payout Limitation. All payouts will be made in full. Every month, the loan agency will deduct 10% of your discretionary income to determine your payment amount.
  • If your monthly payment on a subsidized federal loan is too low to cover the interest accruing each month, the federal government will cover the shortfall for up to three years. At that point, they’ll pay half of the interest. In addition, they pay the entire interest cost of unsubsidized loans at a rate of 50%.
  • As long as you are a REPAYE participant, your loan servicer will not add any accrued interest to your loan balance.
  • If you borrowed money for college, you have 20 years to pay it back, in 240 equal installments. If you have direct loans for graduate study or Grad PLUS loans, or if you have consolidated these loans with another loan, you have 25 years to make 300 payments on your debt.
  • Payments under this plan can be made by any student with Direct Loans or Grad PLUS Loans, regardless of their financial situation. The only way to use your existing FFEL loans is to combine them into a new direct consolidation loan before applying. No REPAYE program will ever be available for Parent PLUS loans. If you are still enrolled 20 years after making payments on your undergraduate loans, or 25 years on your graduate student loans, you will be eligible for loan forgiveness.

4. Income-Based Repayment Program

The Income Contingent Repayment Plan (ICR) has been around longer than any other income-driven plan yet offers the fewest benefits. If you choose ICR, you’ll have to make larger monthly payments for a longer period of time than under any other payment plan. Capitalized interest is subject to a limitation, but regardless of whether you remain in the program or not, it will be capitalized each year.

The eligibility of Parent Bonus loans is a significant plus. However, a federal direct consolidation loan consolidation is still required.

  • Payment Amount. The smaller of 20% of your discretionary income or the amount you would pay over 12 years on a fixed-payment repayment plan is what you must pay each month. You and your spouse can combine your loan payments under the ICR plan if you both have qualified student loans. In this case, your servicer will determine an individual payment amount for each of you based on your individual debt.
  • For the purpose of ICR, your servicer will determine your discretionary income as the amount by which your adjusted gross income (AGI) exceeds 100 percent of the federal poverty level for your family size in your state of residence. If you and your spouse are filing taxes jointly, your servicer will use both of your combined incomes when determining how much you owe. If you and your spouse file separately, they will only count the money you bring in.
  • Limit on Size of Payments. There is no limit on the size of payments.
  • No interest on federal loans is subsidized by the federal government. Every year, your servicer will add up all of the interest accrued and charge you a lump sum. However, this amount cannot exceed 10% of the total debt owed when payment in full was initiated.
  • Payment Schedule, 300 installments spread out over 25 years.
  • In-Consolidation Refinancing (ICR) is available to any borrower who has a Direct Loan or a Direct PLUS Loan from the Federal Family Education Loan Program. The combination of PLUS loans taken out by parents into a Direct Consolidation Loan from the federal government is a requirement for this type of loan.
  • Repayment. After 25 years of on-time payments, your loans will be forgiven if you continue enrolled.

Application Procedures for Income-Driven Repayment Plans

Get in touch with your student loan servicer to join an IDR program. The loan servicer is the financial institution handling your student loan payments and sending you a bill each month. 

They can advise you on the most suitable IDR plan for your circumstances and help you through the application process. If you want to qualify for an income-based repayment plan, you’ll need to fill out a form, which may be found on the Federal Student Aid website or obtained from your loan servicer.

To make payments on any IDR plan, your servicer will need to know how much money you make. After submitting an application, you will be asked to provide proof of income. A person’s most recent Federal Income Tax Return serves as definitive proof of income. Keep this in mind while making a phone application. 

Plus, they’ll require your adjusted gross income (which can be found on your tax return). To finish the application process, you must also submit a copy of your tax return via mail or fax.

A typical IDR request processing time is one month. Your loan servicer should be able to put your loans into forbearance if you require this while they review your request. Loan payments are suspended during the forbearance period. 

However, interest keeps piling on, so the total sum is constantly growing. Refinancing your student loans or having your monthly payments recalculated are also options available to you at any moment. 

If you find that your income-driven repayment plan is no longer beneficial to you because of a job loss, a job change, or a change in family size, you should contact your student loan servicer to discuss other repayment options or to have your monthly payments recalculated.

If the new arrangement would result in more expensive installments, you are under no obligation to accept it. Each year, however, you’ll need to renew your certification.

Recertification

A copy of your most recent tax return must be submitted to your student loan servicer each year as recertification of your income and family size. However, even if neither your family size nor your income has changed, you still need to recertify.

When it is time to recertify, loan servicers will send out notifications to remind borrowers. If you miss the yearly recertification deadline, your loan servicer will remove you from the program and your monthly payment will go back to what it would be under the conventional 10-year repayment plan.

If you miss the deadline for recertification, you can always reapply. There are, however, a few reasons why recertification should not be taken lightly.

You cannot requalify for PAYE or IBR if your income increases to the point where your monthly payment would be more than it would be under the regular 10-year repayment schedule. If you remain a participant, however, your payments will be capped at a certain level.

Second, any interest that accumulates while you are unable to participate in your IDR plan due to your inability to recertify will be capitalized and added to your original IDR plan balance. 

As a result, your servicer will apply interest to the total amount outstanding. The amount owed will continue to grow as interest is accrued on the newly capitalized sum even after you re-enroll in your IDR plan. Even if you put your loans into moratorium or deferment temporarily, this remains true.

Choosing an IDR Plan

Having a conversation with your loan servicer is the first and easiest step in selecting the optimal IDR plan. They have the tools to calculate your eligibility for several plans and provide you with estimated monthly payments for each option.

Don’t automatically go for the plan with the cheapest monthly bill unless you really can’t afford anything else. Weigh the plan’s long-term expenditures against your current requirements. 

One plan could have a longer repayment period but a lower monthly payment. Furthermore, while your interest rate will remain constant across all IDR plans, you may be eligible for additional incentives, such as interest subsidies, that might lower your total repayment obligation.

Even if you believe you will be eligible for PSLF and thereby receive full loan forgiveness in as little as ten years, it is still prudent to consider all of your choices. Since only a small fraction of borrowers are eligible for PSLF at the moment, counting on it may not be a good idea until and until the program is simplified.

Please be aware that not everyone can benefit from an IDR plan. Try out the government’s loan simulator with your actual salary, family size, and loan details before committing to an IDR plan. The calculator provides a snapshot of your prospective monthly payments, total amount owed, and forgiven debt.

Bottom Line

An IDR plan is a good option if you are having trouble making your student loan payments or are at risk of defaulting. There are, however, some downsides to consider. If you want to pay off your student loans faster, it is in your best interest to explore all of your alternatives.

Borrowers may find it difficult, if not impossible, to save for important life goals like buying a house or retiring comfortably due to the weight of their student loan debt. It’s in your best interest to pay off your debt as soon as possible.

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