Many people are intrigued when they read about the REPAYE interest subsidy. However, very few know the financial details surrounding it.
In this article I’ll provide you the financial details you need to know by answering the following questions:
- What is the REPAYE Interest Subsidy?
- Who Can Benefit From The REPAYE Interest Subsidy?
- Who Doesn’t Benefit From The REPAYE Interest Subsidy?
Before diving deeper, I highly recommend reading our income driven repayment guide before continuing if you haven’t already read it.
What Is The REPAYE Interest Subsidy?
As I discuss in our income driven repayment guide, one of the key items to understand when it comes to student loans is the monthly interest charge. The interest charge is the portion of your monthly required payment which is used to pay the interest on your loan. The rest of your payment is used to reduce how much you owe.
If you are on an Income Driven Repayment (IDR) plan and your required monthly payment is lower than the monthly interest charge, that “unpaid” interest is deferred and added to your loan balance. Translation, how much you owe increases.
When you are on an IDR plan other than REPAYE, 100% of that unpaid interest is deferred.
REPAYE is different because it incorporates an interest subsidy. Each month on the 1st, 2nd, or 3rd business day, the government will forgive half of the interest that you deferred from the previous month.
For example, let’s say you are charged $1,000 per month in interest. If your required monthly payment on REPAYE is $300 then you defer $700 in the current month ($1,000-$300). On the 1st, 2nd or 3rd business day of the following month, the government will subsidies $350 of the interest ($700/2=$350). Therefore, your balance only grows by $350.
Note: We include the REPAYE interest subsidy in our income driven repayment calculator. This is important because it gives you a better estimate of your tax liability when your loans are forgiven.
Who Doesn’t Benefit From The REPAYE Interest Subsidy?
Many get enticed by the subsidy that is unique to REPAYE. However, when you do the math, REPAYE doesn’t make financial sense for most people when compared to other IDR plans.
Specifically, if you are pursuing student loan forgiveness and plan on working full-time for 25 years REPAYE most likely is a major disadvantage from a cost perspective. This occurs because REPAYE last 25 years vs. 20 for the other IDR plans.
In most cases, your income in years 20 – 25 will likely be higher than years 1 – 20. Therefore, the amount you pay as a monthly payment will increase faster AND you’ll have to make 60 additional monthly payments.
These extra 5 years of payments often times negate the savings you get from the interest subsidy. Thus, you’d be better off sticking with a 20-year plan and use PAYE or IBR For New Borrowers.
Who Can Benefit From The REPAYE Interest Subsidy?
If you plan on paying off your loan the “traditional” way, i.e. using a pay off strategy but have a short-term decline in income, then you can benefit from the REPAYE interest subsidy. Here is why…
Using REPAYE in the short-run would decrease your monthly payment. The interest subsidy would benefit you since you only plan on using REPAYE for a short period of time. If you elect to go that route, you can change back to a traditional repayment strategy easily when your financial situation improves and you’re able to make the higher monthly payments. You can switch from an IDR to a regular repayment strategy any time at no cost.
For example, we see many physicians or physical therapist doing their residency. During this time their income is low but after the residency is completed, their income will increase and they will want to pay off their loans.
These individuals can benefit from the interest subsidy because they would defer less interest. Therefore, how much they owe would grow more slowly and, ultimately, the amount they would have to repay when they go back to a traditional pay off strategy would be lower.
You can also benefit from the REPAYE interest subsidy if you don’t expect to work full-time for 25 years. The reason being is you wouldn’t have to make the extra 60 payments in years 20 – 25 of the loan because you wouldn’t be working.
Another example is if you aren’t working or have a low income. In this scenario, your monthly payment would be close to $0 per month. This ultra low payment counts as a payment on REPAYE. Therefore, you may find yourself in a situation where you would not have to make payments in year 20-25, when your income would be higher in most cases.
Lastly, if you are on Old IBR, you’ll want to look into REPAYE for a couple of reasons:
- Old IBR is 25 years long and the monthly payment is 15% of your adjusted gross income. REPAYE is also 25 years long (for those that went to grad school) but the monthly payment is only 10% of gross income.
- REPAYE has the interest subsidy and Old IBR does not. Therefore, the tax you will pay when your loans are forgiven will be less if you switch to REPAYE.
However, if you are on Old IBR, the switch is not automatic. Two things to be aware of:
- If you switch, the deferred interest that you already accumulated will be capitalized. e. it will now begin to compound interest whereas currently it does not.
- On old IBR, if you are married then you can file taxes “Married Filing Separately” and the monthly payment is only based on your income. On REPAYE however, your filing status doesn’t matter. Your payment is always based on combined incomes. Therefore, switching may actually cost you a lot.
Most people will not benefit from the REPAYE interest subsidy and are better off using PAYE or IBR. There are unique situations however where you may take advantage of REPAYE.
Want to learn more about student loans and money, be sure to check out our blog.