Beware Savvy Borrowers Using Income-Based Repayment

The U.S. Department of Education has launched a campaign to inform borrowers with federal student loans about the benefits of the Income-Based Repayment plan (which is also called Pay As You Earn for more recent borrowers). Income-Based Repayment, as modified by the Obama administration and Congress, caps borrowers’ payments between zero and 10 percent of their incomes, with loan forgiveness benefits after 10 years of enrollment for those working in the government and not-for-profit sectors and 20 years for everyone else. The Department of Education’s campaign is an excellent opportunity to educate not just borrowers about Income-Based Repayment, but policymakers, too.

Policymakers should learn more about Income-Based Repayment (IBR) for two key reasons. First, IBR is the single best repayment plan for borrowers. It offers the most protection against the risk that borrowers will be unable to repay, for any length of time. Yet, when borrowers begin repaying their loans, the Department of Education automatically enrolls them in a 10-year, fixed-payment plan no matter what their financial situation. That plan has the shortest repayment term–and therefore the highest monthly payments–of any of the options currently available. If borrowers want to use IBR to lower their payments, they first have to know about it, understand it, and then enroll annually. Hence the Department of Education’s campaign.

Given the benefits IBR offers over other repayment plans, why not make it the only one? That would, in fact, be a big improvement over the current system – and the Department’s outreach efforts would be unnecessary. Of course, there would be implementation challenges. But the main impediment to making IBR a universal repayment plan isn't on the implementation side; it’s on the benefits side. That’s the other reason that policymakers must better understand IBR.

In its current form, IBR provides larger subsidies to borrowers who attended graduate school than it does to those who borrowed only to finance an undergraduate education. The federal loan program lets graduate students accumulate very high balances, but imposes low annual and aggregate limits on undergraduates. Because borrowers with big loan balances can repay their loans under the same IBR terms as those with low and moderate balances, the bigger the loan balance, the bigger the benefit. What’s more, these graduate school benefits are available even to borrowers earning a high income during repayment.

For the time being, most students and the general public are not aware of IBR’s big benefits for graduate education. The program is complicated, opt in, and relatively new. Ironically, that’s what makes it viable. Only a few shrewd borrowers have figured this out, minimizing both the costs and visibility of the graduate school benefits – for now.

But making IBR the only repayment plan would ensure that everyone who qualifies for graduate borrowers' large education subsidies does in fact receive them, not just the savvy few who figured out the program, usually with help from a financial aid office or a financial planner. It’s not hard to see how that would threaten the viability of the IBR program. Lawmakers and the public won’t respond favorably when they realize that under IBR (in its current form), the government will provide more in loan forgiveness to someone with a high income and a master’s degree than it will provide in Pell Grants to a student from a low-income family attending a four-year college. Nor will they think it fair that those who borrow and spend more get larger government benefits than those who make more prudent choices or use their own money to finance a graduate degree.

Therefore, a different sort of informational campaign is in order, one that highlights IBR’s outsized graduate education subsidies. It should prompt policymakers to reform the program and redirect those subsidies to students and borrowers who struggle to pay for an undergraduate education. Lawmakers can then make IBR the universal repayment plan, ensuring that its better targeted benefits are automatically available. Here is what that campaign might look like in the form of an email from the U.S. Department of Education addressed to student loan borrowers:

Dear current and future federal student loan borrower:

Please find below a list of ways in which you can take full advantage of the benefits that the Income-Based Repayment program (or Pay As You Earn) provides, particularly if you have attended, or plan to attend, graduate or professional school. Be sure to consider these benefits as you make decisions about borrowing and repaying.

Note: this information applies to all future borrowers and current borrowers who first took out federal student loans after September 2007, and/or took out a loan in 2011 or later. These borrowers can make payments between zero and 10 percent of their incomes and qualify for loan forgiveness benefits after 10 years if they work in the government, for a governmental entity, or in the not-for-profit sector, or after 20 years for all other employment.

1. IBR is not just for low-income borrowers. Middle- and high-income borrowers can qualify for large benefits if they borrow to finance a graduate or  professional education.

Your eligibility for IBR is effectively a debt-to-income test – there is no official income limit. If your loan payments would be lower under IBR than if you paid off your loan in fixed payments over 10 years, you can enroll. If your income later increases, you are not disqualified to have your debt forgiven under IBR. That is, you do not lose the loan forgiveness benefit if your income later increases. You continue to make payments based on your income (or the 10-year repayment plan, whichever is lower), and your debt is forgiven after the requisite number of payments.

The IBR formula is as follows. Annual payments are equal to 10 percent of your Adjusted Gross Income (which is usually less than your salary or how you typically think about your income) after you exclude 150 percent of the federal poverty guidelines according to your household size, or about $17,000 for a single person. To see how that formula doesn't restrict IBR to low-income borrowers, here is an example:

EXAMPLE: Say you are single and earn a salary of $70,000. You contribute a modest sum to a retirement plan, pay health insurance premiums and contribute to a flexible spending account at work, and then deduct your student loan interest. After those adjustments, your Adjusted Gross Income might be around $60,000. To calculate your IBR payment, subtract $17,000 from that amount (150 percent of poverty guideline), which leaves you with $43,000, the amount of income you will use to calculate your payments. Take 10 percent of that amount and then divide by 12. Your monthly payment is $358. You can enroll in IBR so long as that payment is lower than what you would pay monthly to pay off your loans over 10 years. In this case, if your loan balance was higher than approximately $33,000 at 5 percent interest, you can enroll.

Note that if you only pursue an undergraduate degree, you’ll be subject to low annual limits on federal student loans, making it less likely that you’ll accumulate $33,000 in debt in four years. Graduate students, on the other hand, can borrow whatever their educations cost and can easily rack up $33,000 in just one year or even one semester. 

2. You can qualify for substantial amounts of loan forgiveness even if you earn a high income, but you generally will have to attend graduate school to receive those benefits.

There is no income cut-off for loan forgiveness benefits in IBR. If you have a balance at the end of 10 or 20 years while you’ve repaid in IBR, you qualify for loan forgiveness. It doesn’t matter if you’re earning $30,000 at the time or $150,000. You still qualify.

You might think that someone earning a high income will pay off their student loans under IBR before reaching the loan forgiveness point, which imposes a de facto income limit on loan forgiveness. That’s true for those with undergraduate levels of debt but not for graduate levels.

EXAMPLE: Assume that you borrowed the maximum in federal loans to pay for your undergraduate degree (about $27,000 for four years) and then attended a private graduate school using federal loans to pay the entire cost including your living expenses. That leaves you with about a $90,000 balance, counting the principal, origination fees, and in-school interest. Assume your interest rate is 6.5 percent.

Using the income example from #1 (starting salary $70,000), assume your annual raise is 3 percent. You would earn what many would consider a high income for your entire repayment term, yet your payments under IBR would never be high enough to pay the accruing interest on your loan. You would therefore have $91,000 forgiven after 20 years in IBR, at which point you would have an annual income of $123,000 (without taking future inflation into account).

3. There is no limit to the amount of debt that you can have forgiven. However, undergraduates will find this provision of little significance, while graduate students can reap large benefits.

Just as there is no absolute income limit in IBR, there is no absolute limit on how much you can have forgiven. You can have $200,000 forgiven if that’s what you end up with at the loan forgiveness point.

Remember, this benefit is limited for undergraduates because they can borrow relatively small amounts each year in federal loans (between $5,500 and $7,500 for dependent students). Graduate students can borrow up to $20,500 per year with Stafford loans, and then access another type of federal loan (Grad PLUS) that has no limits other than what the school charges, including all living expenses. Borrowers can also combine undergraduate and graduate school loans and then repay them as one balance in IBR.  

 4. There are very easy (and completely legal) ways to shelter your income to reduce your monthly payments and increase the amount of debt you have forgiven. In many cases you won’t even need to take any special steps to shelter your income.

As was discussed earlier, IBR uses a measure of income (Adjusted Gross Income) that excludes a lot of things. For example, any fringe benefits you contribute to at work, such as retirement savings, health benefits, dependent care accounts, or transit and parking benefits, are excluded. You don’t need to do anything extra so that this income is not counted in IBR payments. It happens automatically. You can also exclude up to $2,500 in student loan interest from your income per year (provided your Adjusted Gross Income is less than $75,000).

Because IBR doesn’t count those types of expenses as income, your payments are lower than what you might think based on your total income or salary. And even if it doesn’t seem like much – it may only lower your payment by $50 a month – it adds up over time and boosts how much debt you have forgiven.

Be aware, however, that this benefit most helps those who attended graduate and professional school. Their higher after-school incomes make it easier for them to shelter more income without a big impact on their personal budgets. And because they have debt levels high enough that they will definitely have some forgiven, sheltering income increases how much is forgiven. Borrowers with only undergraduate debt will find that they repay their loans within 20 years whether they take advantage of pre-tax benefits and deductions or not.

Example: Georgetown Law, whose students leave school with an average of $146,000 in federal loans, holds a seminar for its students on the benefits of IBR. As part of that seminar, the school coaches its students on the benefits of increasing retirement savings to reduce their Adjusted Gross Incomes, thereby reducing their loan payments and increasing the amount of debt that is forgiven. You can watch a video clip of that portion of the seminar here.

5. A married borrower can exclude her spouse’s income from IBR and then include her spouse in her household size, reducing her payments and increasing loan forgiveness.

Income-Based Repayment allows you to make payments based only on your income even if you are married. You’ll need to file a separate tax return from your spouse to do this. That’s easy with today’s tax preparation software. So if your spouse earns a high income, but yours is more modest, that won’t disqualify you from IBR and its loan forgiveness benefits.

You may be surprised to learn that even though you file a separate income tax return and therefore do not count your spouse’s income for your IBR payments, your loan servicer will instruct you to count your spouse in your household size. This is not an error. It is how the program is supposed to work. Be sure to take advantage of this benefit. Remember, IBR lets you exempt 150 percent of the federal poverty guidelines from your income, and that number goes up with household size. Adding your spouse to your household size will cut your monthly payment by about $50. And what if you have children? Read #6.

6. You can count your children in your household size and gain a larger deduction, even if you are married, file a separate tax return, and do not claim your children as dependents on your return.

Your household size for IBR includes your children. But what if you file a separate tax return from your spouse so that you can make IBR payments based only on your income? You may be surprised to learn that you can still include your children in your household size so long as you provide more than half of their support. How you file your taxes does not matter in this case.

Thus, if you are married and have two children, earn more than your spouse, but file a separate tax return, IBR will measure only your income and assign you a household size exemption of four! That means you could exclude about $35,000 from your Adjusted Gross Income when your IBR payment is calculated. This can make a big difference for all borrowers, but the benefits are biggest if you borrowed a lot for graduate school.

EXAMPLE: If the borrower in #2 has a household size of four for most of the repayment term, instead a household size of one, total loan payments are lower by $40,000 over the repayment term, boosting the amount forgiven to $146,000, rather than $91,000.

7. You might not think you work in “public service” but there is a 25 percent chance that you do.  In which case you can have your debt forgiven after only 10 years of payments in IBR instead of 20. This is the Public Service Loan Forgiveness program (PSLF).

All of the benefits you’ve learned about in this document are much larger for borrowers working in “public service” because they receive loan forgiveness after 10 years of payments (120 cumulative monthly payments at any point in repayment), not the standard 20 under IBR.

Many people make the mistake of assuming that public service is limited to narrow job categories, like teachers working in low-income schools or attorneys working in the public defender’s office. In fact, what counts as public service encompasses one out of every four jobs in the economy! Moreover, it’s not restricted to “public service” jobs with low pay. There are no income restrictions, just the standard IBR rules. The type or nature of employment does not matter nor does the type of services that the employer provides – just the type of employer matters. And there is a very long list of qualifying employers.

A public service job is one with a federal, state, or local government agency, entity, or a non-profit organization with a 501(c)(3) designation, or a non-profit that provides: emergency management, military service, public safety, or law enforcement services; health services; education or library services; school-based services; public interest law services; early childhood education; public service for individuals with disabilities and the elderly. (See Department of Education info here.)

Now you can see why one in four jobs qualifies. PSLF applies to almost any job so long as it is not at a for-profit business.

8. Higher-earning individuals can qualify for very large benefits under Public Service Loan Forgiveness if they attend graduate school.

The same high earners who would qualify for IBR’s loan forgiveness benefits after 20 years of payments can earn even larger benefits under PSLF because their debt is forgiven 10 years sooner. Moreover, because PSLF encompasses one in four jobs in the economy and does not specify any income limits, borrowers who attended graduate school can pursue a broad set of career choices that pay high incomes and still qualify for substantial loan forgiveness after 10 years.

EXAMPLE: Let’s say you earned an MBA from a private school and left with a loan balance of $90,000 (with a 5 percent interest rate), including undergraduate loans. After you graduate, you land a job in the business office at an elite private university. Your starting salary is $70,000 with annual three percent raises. Based on your debt-to-income ratio, you qualify for IBR and enroll. After a big promotion in your sixth year, your salary is bumped to $110,000. By your 10^th year you earn $124,000, at which point your outstanding balance is forgiven under Public Service Loan Forgiveness.

Your total loan payments would be $62,000 in principal and interest over those 10 years, but if you had fully paid off your loan over that time, they would have been $114,000. Thanks to PSLF, the federal government just handed you a check for $52,000. Again, you still qualify for this benefit despite having never earned less than $70,000 a year over your repayment term and regardless of the fact that you earn a very high income when the debt is forgiven.