How is income-based repayment calculated?

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Income-based repayment plans for student loans work exactly as they sound: Each of these plans calculates your monthly repayment amount based on how much you earn, so your monthly bill can rise or fall. This is one of the main benefits of income-based repayment. Because income-based repayment is calculated based on your earnings, your payment becomes more affordable during lean financial times.

What is income-based repayment?

According to the U.S. Department of Education, an income-driven repayment plan is a student loan repayment option that “sets your monthly student loan payment at an amount that is intended to be affordable based on your income and family size.”

Income-based repayment plans ask you to make your adjusted monthly payment for 20 to 25 years, at which point your remaining loan amounts will be forgiven. However, there’s one major downside that comes with having your loans forgiven through income-based repayment plans — forgiven amounts may be treated as taxable income.

This means that with income-driven repayment plans, you get to pay a lower amount for a long period of time (20 to 25 years), but you could face a spendy tax bill in the end.

Why is it important to me?

Income-driven repayment plans are important for student borrowers who need a lower monthly payment on their loans more than anything else. Since these plans base your monthly student loan income on how much you actually earn, the amount you pay may only be a fraction of what you would pay on a standard, 10-year student loan repayment plan.

Depending on your income and family size, you may not even have a monthly payment at all.

Further, income-driven repayment plans are a requirement if you plan to pursue Public Service Loan Forgiveness (PSLF) with qualified employment in a public service field. With PSLF, you would only make 120 payments on your income-driven repayment plan before having your loan balances forgiven, and amounts forgiven aren’t considered taxable with this option.

Types of income-based repayment plans

There are four types of income-driven repayment plans you can apply for:

  • Pay As You Earn (PAYE): Pay 10 percent of your discretionary income for 20 years.
  • Revised Pay As You Earn (REPAYE): Pay 10 percent of your discretionary income for 20 to 25 years, depending on whether you have undergraduate or graduate loans.
  • Income-Based Repayment (IBR): New borrowers after July 1, 2014 pay 10 percent of their discretionary income for 20 years (borrowers who predate July 1, 2014 pay 15 percent of their discretionary income for 25 years).
  • Income-Contingent Repayment (ICR): Pay 20 percent of your discretionary income (or what you would pay on a fixed repayment plan for 12 years) for 25 years.

Does income-based repayment include spousal income?

If you’re married, whether your spouse’s income will be considered depends on the income-driven plan you select. With REPAYE, your loan servicer will include your spouse’s income when determining your monthly payment, whether or not you file your taxes jointly. However, you may be able to have only your income considered if you are separated from your spouse.

With PAYE, IBR and ICR, on the other hand, your loan servicer will consider only your income if you’re separated or you file your taxes separately from your spouse. If you file jointly, the loan servicer will consider both your income and your spouse’s.

How is income-based repayment calculated?

Loan servicers base your repayment plan on your discretionary income. All servicers use a standard formula to determine this amount, so it’s easy to figure out what yours would be with some basic information.

To determine discretionary income, you’ll look for the difference between your adjusted gross income (AGI) and 150 percent of the federal poverty level for your family size and where you live.

Here’s an example:

Imagine your adjusted gross income is $40,000 and you live in Indianapolis, Indiana. You have $45,000 in eligible federal student loans.

According to the U.S. Department of Education, 150 percent of the 2020 poverty guideline is $19,140 for a family of one. The difference between your AGI and this amount is $20,860. This is your discretionary income. If you paid 10 percent of this amount under an income-driven repayment plan, you would owe $2,086 for the year, or $173.83 per month.

But the math changes if you have three kids. If you’re a family of four, 150 percent of the 2020 poverty guideline works out to $39,300. The difference between this amount and your AGI is only $700, and this is your discretionary income. If you owed 10 percent of this amount on an income-driven repayment plan, you would only owe $70 on your student loans for the year. That’s only $5.83 per month.

Final considerations

Before you decide to pursue an income-driven repayment plan, you should make sure you have the right kind of federal student loans. Note that Direct Subsidized Loans and Direct Unsubsidized Loans qualify for all of the income-driven repayment plans, as do Direct PLUS Loans and Direct Consolidation Loans. However, other types of loans may or may not qualify for income-based repayment plans. You can find out more on the U.S. Department of Education’s website.

Generally speaking, however, most federal loans can qualify for income-driven repayment plans if you consolidate them with a Direct Consolidation Loan first. That may sound like a hassle, but the time you invest can pay off if you need a lower monthly payment and you hope to have your student loans forgiven one day.

Featured image by Dan Rentea of Shutterstock.

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