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 (whether it was the student or a guardian), when the money was borrowed and how much you earn. However, that very complexity offers tremendous flexibility in tailoring student loan payments to your individual circumstances.
There are two types of income-based repayment plans for federal student loans that are generally the most advantageous for student borrowers, the pay as you earn plan (PAYE), and the newer revised pay as you earn plan, (REPAYE). This article will begin to cover the differences between the two plans. A second article will detail another critical difference between the two plans and offer reasons for you to choose one plan over the other.
Default Payment Option Minimizes Interest While Maximizing Payments
The default option for anyone paying back student loans is the 10-year standard repayment plan, under which the loan balance and any outstanding interest is paid off within 10 years, 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. (For related reading, see: Student Loans: What to Do When You Can't Repay Them.)
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 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 Plans Are Similar at First Glance
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% of your discretionary income.
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% 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 2017, he would pay only $391 per month, saving $719 per month ($8,628 per year) compared to 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.
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, and PAYE can often be far more advantageous than REPAYE.
Choose PAYE if You're Married or Will Be Soon
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 your combined incomes.
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 each year.
Assume that Peter in Example 1 marries Nora and that his loan details are the same. To keep things simple, also assume Nora has no student loans. Peter’s separate adjusted gross income (AGI) is $65,000 for 2017. Nora’s AGI 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 $37,000 in federal income taxes. If they file separately, they’ll owe a total of just over $38,000, or roughly $1,000 more.
Under PAYE, Peter can choose to file separately and pay $339 a month (because his family size is now two instead of one), or $4,068 per year. Alternatively, 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 $9,252 per year on his student loan payments ($13,320 – $4,068) if he files separately. That saving is offset by the increase in taxes from filing separately of about $1,000, but Nick and Nora still enjoy a net savings of more than $8,000 per year.
However there is one big caveat: By paying so much less now under PAYE, Peter is potentially increasing the amount of debt that will eventually be forgiven, which, in turn, increases the amount of tax he’ll owe in 20 years.
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. (For related reading, see: Happily Married? File Taxes Separately!)
No Payment Flexibility With REPAYE for Married Taxpayers
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 $1,464 a month under REPAYE, because there’s no cap on the monthly payment. That’s a net increase of about $12,500 more per year than under PAYE. (In this particular example, Peter might be better off switching to another repayment plan or even potentially refinancing with a private lender at a lower rate.)
The next installment in this series, Should You PAYE or REPAYE Your Student Loans?, will cover more differences between the two plans and provide insight into deciding which one is right for your financial situation.
(For more from this author, see: 3 Reasons to Postpone Collecting Social Security.)