Income-based repayment plans, also referred to as IBR, are extremely complex and confusing. To make matters worse, the term income-based repayment is used to incorrectly describe 5 different repayment plans. To keep it simple, if you use an income-based repayment plan, focus on minimizing the risk while maximizing your financial benefits. To minimize the risk and maximize your financial situation you need to understand how they work, develop a plan, and have a good way to implement your plan.
I know student loans cause a lot of anxiety. This guide provides you with the knowledge needed to put yourself in a good financial situation so you can have financial peace of mind
If you want to make sure you are following the right steps, download our income-based repayment plan check list? Input your name and email below and we’ll send it to you.
Table Of Contents
- The Starting Point
- Understanding Income Based Repayment Plans
- Develop A Plan
- Implementing Your Income-Based Repayment Plan
- Income-Based Repayment & Student Loan Refinancing
- Public Service Loan Forgiveness (PSLF)
- Conclusion & Summary
- Rapid Fire Questions & Answers About Income-Based Repayment
The Starting Point
Income-based repayment is often used as a catch all phrase to describe the following federal student loan plans plans: Revised Pay As You Earn (REPAYE), Pay As You Earn (PAYE), Income Based Repayment (IBR), and Income Contingent Repayment (ICR).
Earlier I mentioned there were five versions. The reason is that income-based repayment is split into two plans: IBR for new borrowers and IBR for old borrowers.
However, using income-based repayment as a catch all phase is technically wrong and drives a lot of the confusion. The government classifies all of these plans as income-driven repayment or IDR and they are considered student loan forgiveness plans.
Due to the confusion these acronyms cause, we will keep it simple in this article. We will use the terms income-driven repayment, income-based repayment, and forgiveness to mean the same thing.
Below is a graph that summarizes the relationship among all the acronyms used to describe income-based repayment plans.
One more thing to note, income-based repayment is only available on Federal student loans. They are not available for private loans. Therefore, refinancing private loans is probably the best thing to do.
Understanding Income-Based Repayment Plans
The biggest problem we’ve seen is people have no starting point to understanding how income-based repayment works. Most try to dive right into the complex details of each plan. Therefore, they end up getting extremely confused and quit trying to understand things any further.
Before diving into the details of each plan, you have to understand basics. That is where we are going to start.
Your Required Payment
If you are on an income-based repayment plan, your monthly payment is based as a percentage of your income. Currently, that percentage is 10% or 15% depending on the plan.
To estimate your monthly payment, simply take the percentages above (10% or 15%) and multiply it by your gross income. This is just an estimate and will work for you if you are trying to keep it simple.
For those that want to take it one step further, the actual payment is based on Adjusted Gross Income (AGI). If you’d like to dive deeper into the details, you can check out how to calculate your AGI in this article.
Your Interest Charge: What Is It and Why It Matters
You are charged interest on your student loans each day. This is called the interest charge. If you add up this daily charge over a month, you’ll get your estimated monthly interest charge.
In most cases, your required monthly payment on an income-based repayment plan is lower than the monthly interest charge. When this happens you defer interest, i.e. your loan balance goes up!
For example, if your interest charge is $1,100 per month and your required monthly payment is only $500, then you will defer $600 per month ($1,100 – $500 = $600). This means your loan balance will increase each month by $600. This will continue to happen as long as your monthly payment is lower than your interest charge.
Note: Revised Pay As You Earn (REPAYE) is calculated slightly different. If you’d like to deeper dive into that then read our REPAYE vs PAYE article. However, I recommend reading this guide completely before diving into the nuances of the different plans.
Calculating Your Monthly Interest Charge
Here is how to calculate the estimated monthly interest charge…
Take the weighted average interest rate of your Federal student loans and multiply it by the total balance that you owe. Then divide that by 12 and the result is your estimated monthly interest charge.
The picture below shows you were you can get this information very easily on your free FitBUX membership profile.
Income-Based Repayment Terms
Income-based repayment plans have terms of 20 or 25 years. At the end of the term, the entire amount you owe is forgiven. This part is easy.
However, you have to claim 100% of the forgiven amount as income the year it is forgiven. Therefore, you must pay the associated income taxes on it.
You have to understand how much you will owe, plan for it, and have a way to implement your plan which I dive more into next. I want to emphasize how important this tax is. The scary part is 88% of people on these plans don’t know it exists.
Develop A Plan For The Tax
The first step is calculating your estimated tax liability. Second, you have to understand how it can change over the next 20 to 25 years. Lastly, you have to develop a strategy to save enough over time to pay it when its owed.
Calculating The Tax Bomb
This is a more complex calculation than most people think because the small nuances of how the government calculates your required payment. However, we made it easy for you. In your FitBUX profile, we do the calculation for you.
Here is an article detailing your FitBUX profile and our income driven repayment calculator. It includes a video guide as well.
How Much To Save
I’m going to illustrate how much to save by using an example.
Let’s assume your estimated tax liability is $65,000.
You need to calculate a minimum to save each month that would grow to equal the liability when your loans are forgiven. We call this monthly amount your recommended minimum monthly savings amount.
For example, if you could earn 2% per year on my savings until the date you have to pay your tax obligation, you would have to stash away $220 per month for the next twenty years.
This is assuming that you start putting money aside as soon as you start on my income-based repayment plan. If you did that, you would have the $65,000 I need in twenty years for the tax.
How To Save
As mentioned earlier, income-based repayment last either 20 or 25 years. That is a long time and a lot can change. Therefore, you have to have a sound game plan.
One way to establish a solid plan is to open a dedicated account which will be used only for your “IBR Tax Money”. This could be a savings account at your current bank, an online savings account, or online investment account. Then set-up a monthly auto-deposit for your minimum recommended savings amount (or more).
Treat the minimum recommended savings amount like a monthly payment/a monthly bill you have to pay. Most importantly, after you set that money aside, treat it as though it doesn’t exists anymore. The only time you take the money out of that account is to pay your tax (unless you have a major, major, major emergency). If you need help with these calculations check out our IDR Solution.
Assumptions That Change The Tax Liability
A lot can change over 20 or 25 years. The important thing to remember is that your estimated tax liability will change over time. Thus, how much you need to save each month will change over time.
You can’t simply start saving your initial recommended savings amount each month and forget about it. You have to make sure to stay on top of it and adjust it accordingly!
Below are the three most common items that change the liability associated with income-based repayment plans that you need to be aware of:
- Your income: When we do projections, we assume a 3% annual growth rate. Your income will not grow by exactly three percent every year. In fact, there may be a few years were you don’t work at all! Conversely, you may get a new job or a promotion and this could impact the amount you’ll ultimately owe.
- Your family status: Marriage and children will change your monthly payment. You will have to account for your spouses’ income, their student debt load, and a change in household size when you have children. Thus, your tax liability will change. To see how marriage influences your monthly payment be sure to check out this article. It details what happens when filing taxes separately vs. jointly while on an income based student loan repayment plan.
- Tax rates: We project the amount owed using a 35% tax bracket. However, nobody can predict what the rate will be in 20 or 25 years.
How Does Saving Mitigate The Risk?
This is extremely important so I wanted to dedicate an entire section to it. A lot in your life can change over 20 – 25 years. If you save for the liability and everything goes exactly as planned then great, you will be prepared.
However, what if it doesn’t go as planned? For example, let’s say you get married and your spouse has a good salary with no student debt. In this scenario, you may no longer benefit from income-based repayment because of the increased monthly payment triggered by the additional income. If you are saving for the tax and this happens to you, then you can simply modify your approach and pay off your loans from now on.
If you elect to move to a payoff strategy, you can take all the money from your tax savings account and use it to make a large prepayment on your loans instead. Thus, you put yourself in a win-win situation regardless of what happens in your life, i.e. you don’t have to stress about your student loans any more.
Implementing Your Income-Based Repayment Plan
There are two items to remember when implementing your income-based repayment plan: Recertification and life events.
Recertification: The biggest mistake people make is not recertifying their income once a year. If you don’t recertify your income annually, you will be kicked off of the income-based repayment plan. When this happens, the interest you deferred is “capitalized”. In short, the interest you had deferred will now be charged interest as well. Not good.
Recertification is an important topic and an easy mistake to avoid. For more information on recertification check out the article titled: 2 Costly Mistakes Of Income-Based Repayment Plans To Avoid.
Track Your Tax Savings: As previously mentioned, the liability will change over time. You have continually check this amount to be sure you are saving enough. Below is a picture from our FitBUX Solution showing the recommended minimum to save.
Also, there are three primary assumptions that go into projecting your tax liability: your income, your family status, and tax rates.
If one of these three items changes, you need to reevaluate your situation immediately and see if you need to alter your repayment strategy. Below are the three assumptions, how they affect your tax liability, and the effect on the recommended monthly savings amount.
In the chart below we assume each item goes up. If the item went down then the affect would be the opposite as what is shown:
How to read the following chart: If my income goes up, then my monthly payment goes up, my tax liability goes down, and my recommended minimum monthly savings amount goes down.
If the tax rate goes up, my monthly payment does not change, my liability goes up, and my recommended monthly savings amount increases.
If the return on my investments in my tax savings account increases then my monthly payment and liability are not changed. My recommended monthly savings amount decreases.
Income-Based Repayment and Student Loan Refinancing
This is one of the biggest mistakes we see people make. They want to pursue student loan forgiveness but then they refinance their loans.
When you refinance your Federal loans, you go from a Federal loan to a private loan. Private loans do not qualify for student loan forgiveness! Therefore, if you are pursuing student loan forgiveness for your Federal loans, DO NOT REFINANCE THEM.
If you have a combination of Federal loans and private loans, then refinance the loans that are already private. If this is your situation be sure to check out our free student loan refinance service or check out the reviews of our 10 student loan refinance partners.
Public Service Loan Forgiveness
Many people get confused about Public Service Loan Forgiveness (PSLF). They think it is a repayment plan. However, it is not. It is a feature of income-based repayment plans.
This means this entire guide applies to PSLF as well. However, you have additional items to consider and do if you are pursuing PSLF.
Conclusion & Summary
The key to taking advantage of income-based repayment plans is minimizing the risk and maximizing your financial situation. You do so by having a high level understanding, a solid plan, and a way to implement that plan.
Rapid Fire Questions & Answers About Income-Based Repayment
What are the income-based repayment plan disadvantages?
The two primary disadvantages are interest accrue and the tax that is owed when the loans are forgiven.
How does income-based repayment plans work?
Payments are based as a percentage of your income. Most will differ interest. After a given time the loans are forgiven. At that point your owe a tax on the amount forgiven.
Can you make too much money for income-based repayment plans?
No. However, PAYE is capped at your would be 10 year monthly payment. Click here for more info.
Is income-based repayment a good idea?
This all depends on your understanding of these plans and your personal situation. What is good for one person maybe bad for another.
How long do income-based repayment plans last?
20 years, 25 years, or if your balance on your loans hits $0 before those time periods. Also, if you qualify for PSLF then they can be finished within 10 years.
Will income-based repayment plans hurt my credit score?
Directly no. Indirectly, maybe as you still show a large loan balance. Also, it may be hard to qualify for a mortgage.
What is the difference between income-driven and income-based repayment?
Income-based repayment is a type of income-driven repayment plan. Income-driven repayment is a catch all phrase the government uses to describe 5 different repayment plans.
Is PAYE better than IBR?
IBR for old borrowers, yes. However, you may not qualify for PAYE. In regards to IBR for new borrowers, PAYE and IBR is the same exact thing.
What is the best income-driven repayment plan?
It depends on what you qualify for and your personal financial situation. I highly recommend speaking with one of our expert Student Loan Planners for free.
Should I switch From IBR to REPAYE?
You may not be able to because your loans don’t qualify. If that is the case you have to consolidate your loans and 90% of the time its not worth it if that is the case. Also, it depends which income-based repayment plan you are on (IBR or IBR for New Borrowers).
What qualifies as partial financial hardship?
Does interest accrue during income-based repayment?
If you interest charge is greater than your monthly payment, yes!
What loans are eligible for REPAYE?
All direct loans except Direct Parent Plus loans.
Do I have to include my spouse’s income?
It depends what plan you are on and how you file your taxes.
How do I reduce my IBR monthly payment?
Contributing to a pre-tax retirement account is the easiest way to do this.