If you have federal student loans, then you’ve surely heard about income-driven repayment plans. Income-driven repayment plans, a collection of federal programs that allow graduates to lower their monthly student loan payments to a level that is manageable relative to their income, are understandably one of the most well-known features of federal student loan repayment.
While these plans can be reassuring, there are income-based repayment disadvantages worth considering before you decide to apply. Here’s what you need to know to determine if an income-driven repayment plan is truly right for your student loan situation:
When an income-driven repayment plan can be a life raft
If you really can’t make your monthly payments, income-driven repayment can be a great option. I took advantage of income-driven repayment back in 2009, when I had $28,000 in student debt and (thanks to the recession) the only job I had been able to find after graduation paid me a whopping total of $18,000 a year.
My standard monthly payments would have been several hundred dollars, a huge percentage of my take-home pay. However, income-driven repayment allowed me to bring this amount down to $98 a month. This was still a lot of money, but it was manageable, and I remember feeling grateful and relieved that I could make my payments and also pay rent and buy gas and groceries.
In situations where you feel like you’re drowning in student loan payments, an income-driven repayment plan can act as a life preserver.
Income-based repayment disadvantages to consider
There are income-based repayment disadvantages that you should know about before deciding on a plan. Just because you qualify for an income-driven repayment plan doesn’t necessarily mean you should sign up for one.
Let’s say you owe $50,000 in federal direct student loans and make $50,000 a year. You can calculate your options for income-driven repayment using student loan calculators available at MagnifyMoney. The calculator asks for the amount you owe, your current monthly payment, your interest rate, your adjusted gross income (AGI), your family size, your state of residence, your estimated annual income growth and your marital status. In addition to the debt and AGI details, I entered an interest rate of 6.8%, a family size of one person and selected “Continental U.S.” for state (for Massachusetts). According to the calculator, if you were in this situation, your standard loan payment would be $575 a month.
However, you would also be eligible for four types of income-driven repayment: Revised Pay As You Earn (REPAYE) repayment plan, Pay As You Earn (PAYE) repayment plan, Income-Based Repayment (IBR) plan and Income-Contingent Repayment (ICR) plan. While each of these plans differs a bit from the others, each one would allow you to start off with a monthly payment that’s lower than the standard $575. ICR, for example, would lower your starting monthly payment to $485. REPAYE would lower your starting monthly payment even further, bringing it down to $266.
At first glance, this looks great. After all, who wouldn’t want to have their monthly payment temporarily lowered by several hundred dollars? That’s more money in your pocket, right? Not so fast.
The importance of understanding how interest works
Taking a look at the bigger picture through the calculations above shows income-based repayment disadvantages.
Your monthly payment isn’t the only thing that income-driven repayment adjusts. Selecting a lower starting monthly payment will also change the total amount you will pay over the entire period of loan repayment, as well as how many months it will take you to repay the loan.
While income-driven repayment options may seem like the best choice right now, they do not stop interest from accruing. Over time, this interest can add up in a major way.
Deciding if an income-driven repayment plan is right for you
It is therefore worth thinking carefully about how much you can realistically afford to pay each month. If you’re making $50,000 a year, then your take-home pay, depending on your federal and state withholdings and contributions to benefits, might be somewhere around $2,800 per month. By applying for income-driven repayment, you would basically be saying that you cannot live off of $2,225 per month (that’s $2,800 minus the $575 standard monthly payment).
But is that really true? Can you really not live off of $2,225 per month? And, more to the point, is having a few hundred extra dollars in your pocket each month worth paying potentially thousands of dollars more in interest over the course of your repayment?
Instead, you could consider lowering your living expenses a little. Perhaps you can go out to eat less, quit your gym membership or get a roommate, all of which could save you money in the long run.
And what if you can live off of even less and make bigger payments? For example, if you lived extremely frugally and paid $1,000 per month toward your loans, you’d be debt-free in about 58 months and would only end up paying $58,000 in total. A payment of $1,000 per month may sound like a lot of money — and it is. But if you can make it work, you’ll be saving yourself thousands of dollars in the long run.
In short, while income-driven repayment plans can be a good option in some situations, it’s important to remember that they do not keep interest from accruing. The bottom line is, the bigger the payments you can make on your loans, the sooner they will be paid off, and the less you will have to pay in total over the lifetime of the loan.