Choosing the Right Repayment Plan Can Save You Thousands
Federal student loan borrowers face a bewildering array of repayment options for their loans. Up to eight different plans are available, depending on the type of loan, who borrowed the money (student or parent), when the money was borrowed, and how much you earn.
On the other hand, that very complexity offers tremendous flexibility in tailoring student loan payments to your individual circumstances.
This article compares the two income-driven repayment plans for federal student loans that are generally most advantageous for student borrowers, PAYE (for Pay As You Earn), and the newer REPAYE (for REvised Pay As You Earn).
As we’ll demonstrate, PAYE is very often the hands-down winner at saving you thousands, or even tens of thousands, of dollars over the life of the loans.
Note: A third repayment option that's not discussed here, the Income-Based Repayment (IBR) Plan, is nearly identical to PAYE while being available for more types of federal student loans. Those who are new borrowers on or after July 1, 2014 and who don't qualify for PAYE should generally prefer the IBR plan over REPAYE.
The (Often-Impossible) Default Payment Option
Quick background: The default option for anyone paying back federal student loans is the 10-Year Standard Repayment Plan, under which the loan balance and any outstanding interest is paid off, much like a mortgage or a car loan. This generally minimizes the total interest paid, but also results in the highest monthly payments, which are all too often unaffordable for recent graduates.
When the 10-year plan is unaffordable, your best option is often to pay back the loans under an income-driven repayment plan, which ties the amount of your loan payment to how much you earn, and also offers debt forgiveness for any outstanding loan amounts after 20 or 25 years.
But which income-driven plan is best for you? The government offers four different ones, and choosing the right repayment plan can be one of the most important financial decisions you’ll ever make in life.
For most people, the two best options are PAYE and its newer cousin REPAYE.
PAYE and REPAYE: Similar, on the Surface
The PAYE and REPAYE plans share many basic features and are deceptively similar, until you read the fine print. Under both plans, your monthly payment is determined based on your income and family size, not by the amount of your student loan debt. Both plans limit the payment to 10 percent of your “discretionary income.”
Example 1: Peter just graduated from law school and owes $100,000 in student loan debt, with a weighted average interest rate of 6%. He’s single and makes $65,000 per year as a first-year associate at a law firm. Under the default 10-year payment plan, Peter would have to pay $1,110 per month for 120 months. However, that’s 20 percent of his gross monthly income, and Peter can’t afford that.
Under both PAYE and REPAYE, Peter’s payment would be based on his discretionary income and family size. In 2020, he would pay only $382 per month, saving $728 per month ($8,736 per year) compared with the 10-year plan.
Peter’s monthly payment will vary each subsequent year, depending on his future income, and also on whether he gets married and has children.
Note that, in the example above, because Peter’s payments are determined by his income, not the loan amount, he might not ever repay his loan in full. That’s why both PAYE and REPAYE offer loan forgiveness after 20 or 25 years of qualifying repayments.
There’s no free lunch, though—Peter will have to pay income tax on any amounts forgiven.
Payments under both plans also count toward the 120 payments required for Public Service Loan Forgiveness, which allows for tax-free debt forgiveness in just 10 years.
Where the Rubber Meets the Road: The Two Critical Differences
Despite the surface similarities, these plans differ greatly in important ways. Two features in particular can save or cost you tens of thousands of dollars. In both cases, PAYE can often be far more advantageous than REPAYE.
Critical Difference # 1—If You’re Married, or Expect To Be, You’re Much Better Off with PAYE
Under PAYE, if you and your spouse file separate federal income tax returns, your monthly loan payment is based on your income only, not on the combined income of you and your spouse.
If you file a joint income tax return, your loan payments are based on your combined income and combined federal student loan debt.
PAYE gives you choice and flexibility, because the income you report on your federal income tax return determines the size of your monthly loan payment. In effect, you can determine the size of your loan payment by choosing whether to file separately or jointly each year. That choice can save you thousands of dollars a year.
Example 2: Assume that Peter in Example 1 gets married to Nora, and that his loan details are the same. To keep things simple, also assume that Nora has no student loans. Peter’s separate adjusted gross income (AGI) is $65,000 for 2020. Nora’s is $135,000.
If Peter and Nora file jointly and take the standard deduction, with a combined AGI of $200,000 ($65,000 + $135,000), they’ll owe about $30,207 in federal income taxes. If they file separately, they’ll owe a total of $30,866, or roughly $659 more.
Under PAYE, Peter can choose to file separately and pay $326 a month, or $3,912 per year. (His payment is smaller than in Example 1 because Peter's family size is now 2 instead of 1.) If Peter files jointly with Nora, his monthly payment based on their joint income would be capped at $1,110, or $13,320 per year. (Payment caps are discussed below.)
Peter and Nora can save $9,408 per year on his student loan payments ($13,320 – $3,912) if he files separately. That saving is offset by the increase in taxes from filing separately of about $659, but Peter and Nora still enjoy a net saving of $8,749 per year.
For PAYE, then, as a rule, you’ll want to compare the difference in taxes owed when filing joint versus separate income tax returns against the annual difference in your loan payments when they’re based on joint versus separate income and loans. You can make this comparison and choice every year.
Married taxpayers under REPAYE have none of that payment flexibility. Under REPAYE, your payment is generally based on the combined income of you and your spouse, regardless of whether you file joint or separate federal income tax returns.
In the above example, Peter and Nora would have to pay about $1,451 a month under REPAYE, because there’s no cap on the monthly payment. That’s a net increase of about $13,500 more per year than under PAYE.
(In this particular example, if Peter were enrolled in REPAYE, he might be better off switching to another repayment plan or even potentially refinancing with a private lender at a lower rate, despite the loss of numerous protections and benefits that federal loans offer versus private loans. Information and tips on refinancing with private student loans are available here.)
One big caveat, however: By paying so much less now under PAYE, Peter is potentially increasing the amount of debt that will eventually be forgiven. That, in turn, increases the amount of tax he’ll owe in 20 years.
Critical Difference #2—Repayment and Loan Forgiveness Can Take 5 Years Longer Under REPAYE
Under PAYE, any outstanding loan balance is forgiven after 20 years. It makes no difference whether the loans are for undergraduate or for graduate/professional education. As long as you make 240 qualifying payments, and at least 20 years have passed, your remaining loan amounts can be forgiven.
Under REPAYE, undergraduate loans also are forgiven after 20 years, but graduate school loans aren’t forgiven for 25 years (and until you’ve made 300 qualifying payments).
Moreover, if any of the loans you’re repaying are for graduate school, the payment/forgiveness period for all your loans—undergraduate and graduate—becomes 25 years.
Clearly, making an extra five years of payments under REPAYE until debt forgiveness is achieved is a huge disadvantage. For example, if your monthly student loan payment is $750, having to make those payments for five extra years would cost you $45,000—the price of a decent car.
Other Key Differences You Should Know About
PAYE and REPAYE differ in several other important ways. Under a couple of these, REPAYE is potentially more beneficial, but on most fronts, as we’ve seen, PAYE is often clearly superior. These differences include:
Cap on Your Monthly Payment
Under PAYE, your monthly payment will never be greater than you would have paid under the standard 10-year repayment plan at the time you entered the PAYE program.
Under REPAYE, there’s no cap on your monthly payment. It’s always based on income.
Cap on Interest Capitalization
When interest is capitalized, it gets added to your loan principal amount, which in turn increases the amount of interest that’s accruing on your loan. It’s exactly the same as compound interest on your savings, only in this case it’s increasing the amount of debt you owe.
PAYE caps any interest capitalization at 10 percent of your original loan principal balance. Capitalization occurs only if your income rises to the point that you no longer qualify to make payments based on your income, at which point you simply make the standard 10-year (capped) payment while remaining in the PAYE program.
You’re still eligible for debt forgiveness. The only real effect on you is that capitalization could increase the amount of your debt forgiveness and thus the tax bill.
Under REPAYE, there’s no limit on the amount of unpaid interest that may be capitalized, but this happens only if you’re removed from the plan for failing to recertify your income and family size.
Note that under both programs, if you voluntarily leave the plan, all outstanding interest is capitalized.
Advantage: No Clear Winner
Cap on Interest Accrual
REPAYE limits the interest that can accrue (and potentially be capitalized) on your loans. PAYE offers substantially less help on this.
PAYE restricts borrower eligibility to federal Direct Loan borrowers based on various dates, and requires borrowers to have a “partial financial hardship” to enter the program. (That simply means that your loans must be large in relation to your income.) Certain loans, such as Parent PLUS loans, are excluded.
REPAYE is open to all Direct Loan borrowers, regardless of when they borrowed or their income. As a result, many more people are eligible. It excludes the same loan types as does PAYE.
Making the Right Long-Term Decision
In the end, you need a long-term strategy when figuring out your best path to repaying (or seeking forgiveness for) your student loans. That includes a plan for paying the federal and state income tax you’ll owe in 20 or 25 years when any remaining debt is forgiven.
Keep in mind that you can always switch to any other repayment plan for which you’re eligible. Switching, however, will trigger capitalization of any unpaid interest on your loans.
Your goal should be to choose the program that minimizes the total amount you pay and provides debt forgiveness in the shortest time. That makes PAYE the right answer for most people, provided you and your loans meet the eligibility criteria.
You should also start saving now to accumulate enough money for the taxes you’ll owe on that forgiveness.