Income Based Repayment: Your Questions Answered

Income-based repayment plans, also referred to as IBR, are extremely complex and confusing. 

The key to income-based repayment plans is to focus on minimizing the risk while maximizing your financial benefits. To do so you need to understand:

• How they work;
• Develop a plan; and
• Have a good way to implement your plan.

I discuss these three points below.  In addition, this guide will provide you with the knowledge to put yourself in a good financial situation.  Therefore,  can have financial peace of mind when it comes to your student loans.

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. Income-based repayment (IBR) is split into two versions:

• 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.  The government also refers to them as student loan forgiveness plans.

Due to the confusion these acronyms cause, we will keep it simple in this article.  We will use the following terms to mean the same thing:

• 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 item 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

One big problem.  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 get 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

Monthly payments on income-based repayment plans are 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 an estimate and will work 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. Add the daily charge over a month and 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. In short, your loan balance goes up!

Below is an example:

• Your interest charge is $1,100 per month
• The required monthly payment is only $500

Your loan balance will increase each month by $600 ($1,100 – $500). 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.
• Multiply the weighted average interest rate by the total balance that you owe.
• Divide the result by 12.
• This result is your estimated monthly interest charge.

The picture below shows you were you can get this information very easily on your free FitBUX 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.  I dive more into each of these next.

Develop A Plan For The Tax

The scary part is 88% of people on these plans don’t know about the tax .  I want to emphasize how important this tax is. Developing a plan is critical.

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

The small nuances of how the government calculates your required payment makes this calculation hard. However, we do the calculation for you in your FitBUX profile.

Here is an article detailing and our income driven repayment calculator.

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 grows to equal your tax when the loans are forgiven. We call this monthly amount your recommended minimum monthly savings amount.

For example:

• You can earn 2% per year on the savings until the date you have to pay your tax obligation
• Based on FitBUX’s calculations, you save $220 per month for the next twenty years.

This is assuming that you start putting money aside as soon as you enter repayment. If you did that this then you would have the $65,000 in twenty years for the tax.

$220 is the minimum amount I would want to save. I could always do more than that which is what I recommend everyone try to do.

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).

Assumptions That Change The Tax Liability

A lot can change over 20 or 25 years.

The important item 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 common items that change the tax 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.  This impacts your monthly payment which in turn impacts the tax 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 federal 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.
• 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.

The three items above are risks you face when using one of the income-based repayment plans. The only way to mitigate these risks is to save.

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 tax 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. 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. 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.

Life Events: As previously mentioned, the liability will change over time. This primarily happens when you have major life events such as marriage and children.  You have continually check this amount to be sure you are saving enough. Below is a picture from our Premium membership showing the recommended minimum to save.

Also, there are three primary assumptions that go into projecting your tax liability:

• Your income,
• Family status, and
• Tax rates.

If one of these three items changes, you need to reevaluate your situation immediately.

Below how changes in these three items affect your tax liability and the 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 9 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 if you are pursuing PSLF.

To learn more about PSLF, make sure to visit our comprehensive our Public Service Loan Forgiveness Guide. In addition, we have a public service loan forgiveness calculator that you can use as well.

Rapid Fire Questions & Answers About Income-Based Repayment

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.

By Joseph Reinke, CFA, Founder of FitBUX