The first article in this series offered a comparison between two repayment options for federal student loans, the pay as you earn plan (PAYE), and the newer revised pay as you earn plan (REPAYE). Because choosing the right repayment plan can save you thousands of dollars, this article will provide more information about the differences between the two plans, and how to determine which plan is best for your financial situation.
Repayment and Loan Forgiveness Can Take Longer With REPAYE
Under PAYE, any outstanding loan balance is forgiven after 20 years. It makes no difference whether the loans are for undergraduate or 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.
Four Important Differences Between PAYE and REPAYE Plans
The PAYE and REPAYE plans differ in several other important ways. Under a couple of these, REPAYE is potentially more beneficial, but on most fronts, PAYE is often superior. These differences include:
1. Monthly payment cap: Under PAYE, your monthly payment will never be greater than what 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.
2. Interest capitalization cap: When interest is capitalized, it gets added to your principal loan 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% of your original loan principal balance. Capitalization only occurs 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 only happens if you’re removed from the plan for failing to re-certify 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
3. Interest accrual cap: REPAYE limits the interest that can accrue (and potentially be capitalized) on your loans. PAYE offers substantially less help on this.
4. Who is eligible: 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 (i.e. your loans must be large in relation to your income). Certain loans, such as Parent PLUS loans, are excluded. (For related reading, see: Federal Direct Loans: Subsidized vs. Unsubsidized.)
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 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.
(For more from this author, see: The Case for Collecting Social Security Early.)