How does Pay As You Earn (PAYE) work?

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If you’re struggling to keep up with your student loan payments, you’re not alone. Around 11 percent of student loan borrowers are 90 days or more past due on their payments, according to the Federal Reserve.

The good news is that the U.S. Department of Education offers several income-driven repayment (IDR) plans that might improve your situation. The Pay As You Earn Repayment Plan (PAYE Plan) is one IDR plan worth reviewing if you feel overwhelmed by your monthly student loan payments.

What is Pay As You Earn (PAYE)?

Pay As You Earn is a type of income-driven repayment plan that aims to make federal student loan payments affordable for qualified borrowers. Under PAYE, your monthly payment isn’t determined by your loan balance. Rather, it’s typically capped at 10 percent of your discretionary income — but never higher than the 10-year standard repayment amount. The Department of Education defines discretionary income as the difference between your annual income and 150 percent of the poverty benchmark for your state (based on family size).

With the PAYE plan, your repayment term lasts for 20 years. At the end of that period, any outstanding student loan balance may be eligible for forgiveness, provided you kept up with your payments as agreed. If you do qualify for forgiveness, be sure to speak with a tax professional. There’s a chance that you may need to count the forgiven loan balance as additional income on your tax return.

It’s also important to understand that your monthly payments under PAYE may be too small to cover the interest charges on your loan. When this happens, it’s called negative amortization.

However, your interest charges won’t be capitalized — in other words, added to your principal loan balance and charged more interest — unless you leave the PAYE plan or no longer qualify due to a change in income. If you no longer qualify to make income-based payments, any unpaid interest you accrued will only be capitalized up to 10 percent of your loan balance when you started the plan. But if you leave the PAYE plan, there is no limit on unpaid interest capitalization.

How do you qualify for PAYE?

Although many people would love to lower their student loan payments, only certain borrowers will qualify for the Pay As You Earn plan. If you have a Direct Loan or a consolidated FFEL Program loan, you may be eligible for PAYE by satisfying the following criteria:

  • Your payment amount (based on 10 percent of your discretionary income) would be smaller under PAYE than under the standard 10-year repayment plan.
  • You received your qualifying federal student loans on or after Oct. 1, 2007 (with at least one loan disbursement of a Direct Loan on or after Oct. 1, 2011).
  • You were a “new borrower” who didn’t owe outstanding federal student loan balances when you received those loans.

You also need to be current on your student loan payments (or close to current) when you apply for PAYE. Borrowers who are in default do not qualify for income-driven repayment plans.

How to apply for PAYE

You can visit Studentaid.gov to fill out an application for Pay As You Earn or any other income-driven repayment plan. There’s no cost to apply, but you may be contacted by private companies that offer to help you with the application process for a fee.

You’ll need to finish the application in a single session. If you gather the information you need in advance, the application process should take around 10 minutes to complete.

Information you need for your application includes:

  • Personal information: Provide your full name, address, email address, phone numbers, best time to contact you, etc.
  • Financial information: You can use an online IRS data retrieval tool to document your income. If you’re married, you may need to include your spouse’s information as well.
  • Verified FSA ID: Confirm or create the username and password that can serve as your legal signature.

Remember, in addition to applying for PAYE initially, you’ll also need to recertify your eligibility for the plan every year.

PAYE vs. income-based repayment

The Income-Based Repayment Plan, or IBR, is another popular way for qualified borrowers to modify the terms of their federal student loans. Both PAYE and IBR plans have the potential to lower monthly student loan payments. Yet there are some key differences between these two options.

PAYE IBR
Qualification Criteria
Available to borrowers with qualifying loans issued on or after Oct. 1, 2007 with a loan disbursement on or after Oct. 1, 2011. Adjusted payments (based on income) can’t exceed the standard 10-year repayment plan. Available to borrowers with qualifying federal student loans issued on any date. Adjusted payments (based on income) can’t exceed the standard 10-year repayment plan.
Monthly Payment
10% of discretionary income 10%–15% of discretionary income (based on date loan issued)
Loan Forgiveness
Available after 20 years Available after 20–25 years (based on date loan issued)
Interest Benefits
Government pays interest not covered by monthly payments for three years Government pays interest not covered by monthly payments for three years

How to determine if PAYE is right for you

Pay As You Earn isn’t right for every federal student loan borrower. In fact, it features some of the strictest qualification requirements of any income-driven repayment plan. PAYE might benefit you under the following conditions:

  • You expect your income to remain low. You must demonstrate a partial financial hardship to qualify for the PAYE plan. If your income rises in the future, you might not qualify to recertify.
  • You’re married and both you and your spouse earn an income. PAYE gives you the option to file taxes separately and have your student loan payments based solely on your income.
  • Your student loans include graduate school debt. PAYE will forgive eligible student loan balances after 20 years for both undergraduate and graduate studies.

You should also get an idea of how much the PAYE plan may save you compared with your current student loan repayment plan and any other options you may be considering. Bankrate’s student loan calculator is a free tool you can use to make a more informed decision.

Other ways to lower your student loan payments

The Pay As You Earn Plan works well for many borrowers who are trying to lower their student loan payments. However, if you don’t qualify for PAYE or you don’t believe that it’s the best fit for your situation, there are other options to consider.

First, there’s a chance that you may qualify for different federal student loan repayment plans. Some plans are income-driven, like Revised Pay As You Earn, while others, like extended repayment plans, aren’t based on how much money you earn.

You might also consider refinancing your student loans through a private lender. If you qualify for a better interest rate, this option might lower your monthly payments and save you money in interest over the life of your loan. In exchange, however, you’ll give up certain government benefits, like the income-based repayment plans mentioned above and student loan forgiveness. So, it’s critical to consider both the benefits and the drawbacks before you decide whether or not to refinance federal student loans.

Featured image by Lordn of Shutterstock.

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