With the federal government’s new income-based student loan repayment program now open for business, some counselors are advising caution. The lower monthly payments under this option may have long-term costs that could hurt you financially, if you don't plan ahead.
The REPAYE program (Revised Pay As You Earn), which launched December 16, gives every American with a federal student loan the option of capping monthly payments at 10% of disposable income. The most flexible and generous of the government’s income-based programs, it streamlines what is now a confusing menu, though it will not replace all other options.
The new lower cap of 10%, widened to include all outstanding federal student loans, includes a forgiveness feature. Any loan balance remaining after 20 years of payments will be wiped away for undergraduate loans. If you borrowed money for graduate school, the forgiveness comes after 25 years.
No question, REPAYE is a great option for those who are struggling with monthly bills. This year someone earning $30,000 would see payments capped at about $103 a month, according to the National Foundation for Credit Counseling. But choosing flexible loan terms can have long-term consequences. To make sure you know the trade-offs, here are three questions to ask before you jump into REPAYE:
- Will your monthly payment reduce your balance? Check to see whether your monthly payment will cover both the principal and interest due on the loan. If it doesn't, your balance will keep growing, which can mean financial trouble over the long-term, says Bruce McClary, spokesman at the NFCC. That outcome would be similar to the financial predicament facing home buyers with negative amortization loans before the housing bust. Their low payments weren’t enough to cover principal and interest—by design—and their mortgages kept getting bigger. When housing values stopped rising, many wound up losing their homes. Of course, your education can't be repossessed, but there are other consequences, so keep reading.
- How much more in interest will you pay? By stretching out your loan, you inevitably pay more in interest, which is money that could have been saved for your financial goals. And if your loan balance keeps growing, it may hurt your credit score, thereby making it harder to get favorable terms on credit cards and mortgages.
- Will you be able to handle a big tax bill? Under current law the loan amount that is wiped out will be treated as ordinary income, which is taxable. If the forgiven debt is sizeable, wiping it out may push you into a higher tax bracket, so you could end up paying the tax at an increased rate. The Obama administration hopes to make forgiven federal student loans a tax-free event, but he’ll need Congress to go along. In other words, don't count on that happening anytime soon.
Depending on your income level and the amount of student debt, which may include graduate school loans, other repayment alternatives may be better than REPAYE. The checklists offered by TICAS and the National Association of Federal Student Aid Administrators will let you compare the details of the different plans at a glance. And you can run the numbers for your loan balance at the Department of Education's online Repayment Estimator.
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