Student loan repayment is a complex process with a great deal of misinformation. The most important part of repaying your student loans is not to default and to stay current. The Income Based Repayment (IBR) and Pay as You Earn (PAYE) are very good programs to help you do this. The problem is that IBR and PAYE maybe cheaper but may not be better for your financial future, if you do not qualify for the Public Service Loan Forgiveness Program (PSLF).
The government has just announced a new program that will be promoting these repayment methods to reduce the current increase in default rates. Here is the link to the announcement. The colleges and loan services are only focus on getting you to stay current. They do not explain the consequences of these decisions on your long term financial future.
When you investigate the various income determine repayment methods, you need to understand the negative loan amortization of each method. Negative loan amortization is a fancy term that means your underpayment is being added to your loan balance. For people who qualify for the PSLF this is not a concern since the debt will be forgiven tax-free. For those who do not qualify this loan forgiveness program your debt will increase and can have a negative impact to your financial future. To qualify for loans such as a car or home, the lender will review your total debt and your debt to income ratio. If this is not a good number, you will be denied. This information is normally not explained to students in their repayment decision process. The lowest payment may not be the best solution for this reason.
There are other issues to consider that may impact IBR and PAYE as a payment solution:
- You may need to file your taxes married & separate to maintain your payment amount. This may increase your tax burden.
- You will need to re-qualify each year.
- The PSLF program is limited to certain payment methods.
- The normal loan forgiveness at 20 (PAYE) and 25(IBR) years is a taxable event. Depending on your loan balance, your tax burden on the forgiveness could be as high as 39%.
- Your option may limit your career flexibility to maximize your loan forgiveness.
This brief list of items needs to be considered before your make your decision. The interest and penalties are severe if you fall behind and this should be avoided at all cost. With your federal loans, there are 8 different methods to consider. Creating the best solution may require both a short term and long term plan.