Income-Based Repayment: Your Questions Answered


August 20, 2020

By Joseph Reinke, CFA, Founder of FitBUX

Income-based repayment plans, also referred to as IBR or student loan forgiveness, are extremely complex and confusing. To make matters worse, the term income-based repayment is used to incorrectly describe 5 different repayment plans. In addition, 88% of people on these plans don’t know how they work!

Long story short, our technology and services have helped new grads build financial plans for more $1 billion in student loans…. and there is massive confusion regarding these income-based repayment plans.

The key is minimizing the risk of these plans 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.

This guide will walk you through each of the above and give you the knowledge needed to put yourself in a good financial situation.

In addition, we will use the term income-based repayment the way most use it. We will use it to generically define 5 Federal student loan repayment plans: Revised Pay As You Earn (REPAYE), Pay As You Earn (PAYE), Income-Based Repayment (IBR), Old Income-Based Repayment (also referred to as IBR), and income contingent repayment (ICR).

If you want to make sure you are following the right steps, download our income driven repayment plan check list? Input your name and email below and we’ll send it to you.

Income-Based Repayment Guide Table Of Contents

  1. The Starting Point
  2. Understanding Income Based Repayment Plans
    1. Your Required Payment
    2. Your Interest Charge: What Is It & Why Is It Important?
    3. Calculating Your Monthly Interest Charge
    4. Income-Based Repayment Terms
  3. Develop A Plan
    1. Calculating Your Tax Obligation
    2. How Much To Save
    3. How To Save For The Tax Liability
    4. Assumptions That Change The Tax Liability
    5. How Does Saving Mitigate The Risk
  4. Implementing Your Income-Based Repayment Plan
  5. Income-Based Repayment & Student Loan Refinancing
  6. Public Service Loan Forgiveness (PSLF)
  7. Conclusion & Summary
  8. Rapid Fire Questions & Answers About IBR

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 IBR 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 and in terms most are used to.  We will use the terms income driven repayment, income based repayment, and student loan forgiveness interchangeably throughout this guide.

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.

Below is a graph that summarizes the relationship among all the acronyms used to describe income based repayment plans.

Income based repayment plan Student Loan Forgiveness chart

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.  (President Trump and other presidential candidates have discussed changing this).

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). AGI is also called discretionary income. If you’d like to dive deeper into the details, you can check out how to calculate your discretionary income 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 IBR plan is lower than the monthly interest charge.

Therefore, it is extremely important to know what your monthly interest charge actually is because it determines how much you will defer each month. In turn, how much you defer each month determines how much your loan balance increases each month (Click here to learn more about interest deferral).

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. This will continue to happen as long as your monthly payment is lower than your interest charge.

Note: President Trump recently extended the 0% interest policy through December 31, 2020. Therefore, you have a $0 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…

Multiply the weighted average interest rate of your Federal student loans and multiply it by the total balance. 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 FitBUX Profile.

Weighted Average Interest Rate

Income-Based Repayment Terms

IBR 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.

That is the most important item you have to be conscious of while on an income driven repayment plan…the tax implication.

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.

Develop A Plan

As previously mentioned, the most important item to plan for is the tax liability you’ll owe when your loans are forgiven.

The first step is calculating your estimated tax liability. Then you have to understand what can change the estimated tax liability over the next 20 to 25 years. Lastly, you have to develop a strategy to save enough over time to cover your estimated tax bill.

Calculating Your Tax Obligation

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.

Income Based Repayment Estimated Taxes

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. I need to develop a plan to save for this.

To do so, you need to calculate a minimum to save each month that would grow to equal the estimated tax liability when your loans are forgiven. We call this monthly amount your recommended minimum monthly savings amount.

For example, if I could earn 2% per year on my savings until the date I have to pay my tax obligation, I would have to save $220 per month for the next twenty years.

This is assuming that I start putting money aside as soon as I start on my income-based repayment plan. If I did that, I would have $65,000 saved in twenty years to cover the tax I owe.

$220 is the minimum amount I would want to save. I could always save more than that which is what I recommend. The more you save and the earlier you save it the better.

How To Save For The Tax Liability

As mentioned earlier, income-based repayment last either 20 or 25 years. That is a long time to save. 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 to set your “IBR Tax Money” aside. 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 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 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 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 driven student loan repayment plan.
  • Tax rates: We project the tax liability using a 35% tax bracket. However, nobody can predict what the tax rate will be in 20 or 25 years.

The three items above are risks you face when using one of the IBR plans. The only way to mitigate these risks is to save. As I mentioned above, the more you save and the sooner you save it the better.

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.

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 tax liability will change over time. You have to save at least the recommended minimum each month and 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.

Required Minimum Savings For Income Based Repayment Plan Tax Obligations

 

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 tax 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 tax liability are not changed. My recommended monthly savings amount decreases.

Income Based Repayment Chart Of Assumptions & The Effect On Taxes

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 Ultimate Student Loan Refinancing guide 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.

To learn more about PSLF, make sure to visit our comprehensive PSLF resource page.

We have an entire article dedicated to PSLF so be sure to check out our Public Service Loan Forgiveness Guide. In addition, we have a public service loan forgiveness calculator that you can use as well.

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 IBR

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 IBR plan you are on (IBR or IBR for New Borrowers).

What qualifies as partial financial hardship?

Check out this article.

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.

 

If you want to learn more ways to optimize your money, be sure to check out our blog page. If you want help with your student loans, then click here to find out why we are expert student loan planners relative to other in the finance industry.

Our FREE student loan planners have helped thousands of Young Professionals manage and eliminate over $1 billion in student loans. We help you develop your plan for free because planning your financial future should not cost you your financial future.

Summary
Income Based Repayment: Your Questions Answered
Article Name
Income Based Repayment: Your Questions Answered
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We've helped new grads manage over $1 billion on income based repayment plans. Check oour our income based repayment guide to get answers.
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FitBUX
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IBR, Income Based Repayment, PAYE, REPAYE, Student Loan Forgiveness
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