The Long-Term Cost of Income-Driven Repayment
Choosing an income-driven repayment plan can make your student loan payments manageable if your income is too low to support a standard repayment schedule. But income-driven repayment plans require longer repayment than a standard plan. Payment amounts change over time depending on your income, which can affect the total cost of your loan.
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Lower Monthly Payments Can Cost More
Income-driven repayment plans can make student loan payments more affordable by adjusting monthly payments based on a borrower’s income rather than the balance. These plans can significantly reduce payments for borrowers with limited income, while making it easier to avoid delinquency or default.
However, lower monthly payments typically translate to longer repayment periods.
“Income-driven repayment plans can be a lifeline for borrowers who are struggling financially, as they are intended to make monthly payments more affordable (because they are based on income rather than the loan balance),” says Leslie H. Tayne, finance and debt expert and founder of Tayne Law Group. “The flipside is that the consumer could end up paying more over the life of the loan.”
A lower payment could be the right choice if you need room in your budget, but the long-term cost depends on how long the repayment lasts and whether you qualify for loan forgiveness.
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How Older Income-Driven Plans Compare With RAP
Not all income-driven repayment plans work the same way. Older plans, such as Income-Based Repayment or Pay As You Earn are different than the Repayment Assistance Plan for new borrowers. These differences affect how interest accrues, the length of repayment and how much you pay over time.
Typically, IBR and PAYE set payments based on discretionary income with loan forgiveness after 20 or 25 years of qualifying payments. Borrowers with limited income may have low required payments, sometimes so low that they do not cover the interest accrued each month.
With IBR and PAYE, unpaid interest can accumulate and cause balances to grow over time, says Stacey MacPhetres, senior director of college finance for Bright Horizons. She says the new RAP offers an unpaid interest waiver that prevents balance growth, but extends the forgiveness timeline to 30 years.
Under RAP, borrowers may pay more over the life of the loan despite stronger interest protections.
[Read: Best Student Loans for Graduate School]
What A Low Income-Driven Repayment Can Look Like
Income-driven repayment can make your monthly bill more manageable, but the numbers vary depending on your income, loan balance and plan.
Compare the payments and costs for a borrower with $40,000 in federal student loans at a 6% interest rate, earning $70,000 annually with no dependents. Under a standard 15-year repayment plan for a $40,000 balance, the borrower would pay about $337 per month and about $60,000 over the life of the loan. With IBR or PAYE, the monthly payment would be $388, with forgiveness after 20 years, for a total cost of about $93,000.
Income-driven repayment plans that stretch payments out 25 years or more can cost significantly more. For example, an Income-Contingent Repayment plan would have a payment of $390 with forgiveness after 25 years for a total of about $117,000. RAP payments would be $350 for 30 years and cost about $126,000.
For this borrower, the standard repayment plan has the lowest monthly payment, the shortest payment period and the lowest total cost. But a borrower with $50,000 in annual income could fare better with income-driven repayment. For a borrower with $50,000 in annual income, all income-driven repayment plans except ICR have lower monthly payments and total costs than the standard repayment plan.
However, these calculations assume the same income across the full repayment period of 15 to 30 years, depending on the plan. If you have an income-driven repayment plan, your monthly payment will adjust with your income as you recertify it annually. You could see significant savings in monthly payments and projected total loan cost when you’re new in your career and likely to have a lower income, but the benefits of income-driven repayment may be negated as your income increases.
Income-driven repayment plans will be streamlined in July. The only plan for new borrowers will be RAP, and existing borrowers in ICR or PAYE will need to transition to either IBR or RAP by July 1, 2028.
The right plan depends on your current income and what you expect to earn during the repayment period.
“For borrowers with tight household budgets, it can be helpful to think of lower monthly payments as temporary breathing room instead of a permanent solution,” says Tayne. “If and when your financial situation improves, consider contributing more funding to your loan balance, or channel windfalls (such as a tax return) to your loans. This will help you not only reduce your balance, but limit the cost of interest, too.”
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The Long-Term Cost of Income-Driven Repayment originally appeared on usnews.com