When you’re struggling financially and can’t afford your monthly loan repayments, income-driven repayment (IDR) plans can offer much-needed relief. These plans are designed to make your monthly repayments affordable regardless of income. As with any financial matter though, there are pros and cons to switching from a standard repayment plan to an income-driven repayment plan for student loans. Before you apply to an IDR program, it’s important to understand how they work and how they can affect your student debt and your finances overall.
Here’s what you need to know about income-driven repayment plans so you can determine whether or not this is the right option for you.
What Are Income-Driven Repayment Plans? How Do They Work?
Income-driven repayment plans for student loans are offered by the federal government. They apply only to federal student loans.
Ten years is the default student loan repayment schedule. However, not all borrowers can afford the monthly repayment amounts with this schedule. Students with higher loan balances find it even more challenging as their monthly repayments can be very high. Missing payments is not as option as that adds late fees and interest to their debt making it even more expensive. This is where the income-driven repayment plans for student loans can help.
Income-Driven Repayment plans are personalized to each borrower in that they base the monthly repayment amounts to your income and family size. There are 4 plans under this program. They all set payments at a percentage of your discretionary income. Discretionary income is the income that’s remaining after deducting allowances for mandatory expenses such as basic living expenses and taxes.
The required payment differs in percentage of discretionary income for each plan. The four income-driven repayment plans for student loans include:
1. Income-Contingent Repayment (ICR) – 20% of discretionary income
2. Income-Based Repayment (IBR) – 15% of discretionary income
3. Pay-As-You-Earn (PAYE) – 10% of discretionary income
4. Revised Pay-As-You-Earn (REPAYE) – 10% of discretionary income
Setting the payments as a small percentage of your income means they will always be affordable. Unless your income is very high, any of the IDR plans will also automatically lower your monthly cost.
Advantages of Income-Driven Repayment Plans
Lowers monthly repayments and makes them more manageable
This is the primary reason most borrowers enroll in the IDR program. If you’re looking for a way to lower the monthly payments on your federal student loans and do not want to refinance with a private lender, IDR plans are the best alternative. The advantage income-driven repayment plans over refinancing is that they lower your monthly payments while still protecting your federal loan benefits.
Adjusts monthly repayments when your income or family size changes
When you enroll in the IDR program, your monthly repayments are based on your income and family size at the time of enrollment. If your income or family size changes in a few years, you can recertify your IDR plan. Showing proof of the change will recalculate your monthly payments accordingly. This can be very useful if your income decreases or you welcome a new baby into the family and need to lower your monthly payments even more.
Payments could be $0
If your adjusted gross income is lower than a certain percentage of the poverty line (it’s different for different plans), your monthly repayments may be set to $0. That payment of $0 still counts toward loan forgiveness.
The remaining balance may qualify for student loan forgiveness
Depending on which income-based repayment plan you choose and the date you first took the loan, you may qualify for student loan forgiveness after 20 to 25 years of on-time payments. In a recent post-COVID statement it was further announced that forgiven amounts won’t be liable to federal income tax at least through 2025.
Can be a life-saver if you’re unemployed
If you have no income coming in and you’ve already used up your economic hardship deferment, unemployment determent and forbearances, an IDR plan can be an absolute life-saver. Since monthly repayments are based on your income, $0 income means you’re payments will also be set to $0. This allows you to use your limited recourses for other urgent expenses.
There’s no negative impact on credit scores
Even if your payment is set to $0, it will be reported to the credit bureaus as an on-time payment. This is a huge advantage as it allows you to continue building your credit score making it easier for you to qualify for low-cost loans later.
Downsides Of Income-Driven Repayment Plans
You’ll take longer to repay your federal student loans
The lower monthly payments will stretch the standard 10-year repayment plan to about 20 to 25 years depending on the plan you choose.
Higher interest accrues on the longer loan term
While lower monthly payments make them more affordable, more interest accrues over the longer term. By the time you clear the debt completely using an IDR plan, you will have paid much more than you would with the standard 10-year plan.
The total loan balance could increase
If your student loan balance is very high, your monthly loan payments may be lower than the new interest that accrues every month. In that case, the interest goes unpaid and is added to your balance in what is called negative amortization. This causes the loan balance to increase instead of reduce.
Your income may be too high to qualify
You may want to lower your monthly repayments for a number of reasons other than a low monthly income. However, if your income is above the minimum set by the federal government then your application won’t be approved.
Should You Consider Income-Based Repayment To Lower Your Monthly Costs?
Income-driven repayments plans are definitely a good option to lower your monthly costs. However, if you don’t think you’ll need the protections of the federal loans, refinancing may be a better option especially if your credit score has improved.
With federal loans, when you switch from a standard repayment plan, only your monthly payments change. Your interest rate remains the same. With refinancing, the monthly payments and interest rates change. Calculating your interest rates will be based on your credit score. A higher score will qualify you for a lower rate when you refinance, which translates to higher savings.