Pay As You Earn: Is This Income-Driven Plan Best For You?

One of the most frustrating things about student loans is that you may not earn enough to easily make the monthly payments you took on to get that job in the first place. If you have federal student loans, however, you have a lot of repayment choices for tricky scenarios like this. One of the most popular options is enrolling in the Pay As You Earn plan (also known as PAYE).

The biggest draw of the PAYE plan is that it caps your monthly payments at 10% of your discretionary income, and after 20 years, the remaining balance can be forgiven. It sounds like a sweet deal—and it is—but it’s not entirely a free ride. If you’re considering the PAYE plan as a way to get help with your monthly payments, it’s important to understand fully how this program works so that you can plan for its drawbacks too.

What Is Pay As You Earn (PAYE)?

The Pay As You Earn (PAYE) repayment plan is one of four income-driven repayment (IDR) plans for federal loans. Each one has slightly different rules about how much your monthly payments will be, how long you have to make those payments for and how the interest portion of your loan is treated.

The PAYE plan is particularly good if you:

• Have loans for graduate school
• Are married to a higher-earning spouse
• Don’t expect any big income jumps over your career

How Your Monthly Payments Are Calculated

The reason people seek out the PAYE program is because it, along with income-based repayment (IBR) plans, lowers your monthly payments the most. With PAYE, your payments are capped at 10% of your discretionary income. If your income rises, payments will never be higher than your monthly payments would be on the 10-year standard plan.

The way the Department of Education calculates your “discretionary income” here is a little complicated. First, it takes your annual income. Then, it subtracts “150% of the poverty guideline for your family size and state of residence.”

For example, if you live in Alabama and support a stay-at-home spouse and two kids, this number works out to $39,300. If you earn $45,000 per year and subtract this number, this means your discretionary income is actually $5,700. If you take 10% of that amount and divide it by 12 months, your monthly payment would then be $47.50.

Each year you’ll need to resubmit a recertification form with your current income, family size and location. If these things change, your monthly payment amount could change over time, too.

How Your Spouse’s Income Figures Into the Mix

One of the advantages of the PAYE plan is that by filing separate tax returns from your spouse, you can prevent their income from figuring into the calculation. This can be really handy if you earn a lower income than your spouse.

You might not qualify for the PAYE plan if your income is considered together, but if you file separately, you might still be able to sign up for the PAYE plan in this way. If this sounds like you, it’s also a good idea to consult with a tax expert because there are other things to consider when choosing your filing status in addition to whether you’ll get a lower monthly payment.

Loan Forgiveness

Another big benefit of PAYE is that at some point, your loans will be forgiven. After you’ve been making payments on the loans for 20 years, they will be forgiven—but the forgiven amount is considered taxable income in the year that it’s forgiven. The amount of taxes you owe on that amount will depend on what your income tax bracket is at the time.

This means that if you have a balance of $20,000 still left on the loan when it’s forgiven, for example, and you’re in the 12% tax bracket, you could owe a tax bill of $2,400 that year. Some financial experts refer to this as a “tax bomb,” and it’s a good idea to start saving money for it so that when you do have to pay this bill, you’ll have enough money and won’t need to go further into debt.

How Interest Is Handled

When you make a payment on any student loan, it’s split up into two parts. Your payment first goes toward paying interest, and then what’s left over goes toward paying down the loan balance.

One of the tricky parts about PAYE and other plans is that your monthly payment may be so low that it doesn’t cover the interest portion of the payment. When that happens, your balance never really goes down, and unpaid interest will start to pile up.

Sometimes, that unpaid interest will be added back to the balance of the loan through a process called “capitalization.” When unpaid interest is capitalized, it means that you have an even larger balance to pay off, and interest will start piling up even faster in a sort of snowball effect.

If you’re able to keep making your payments as normal under the PAYE plan until the loan is forgiven in 20 years, you won’t have to worry about interest being capitalized. But if you no longer have a “partial financial hardship,” such as if your income rises and/or your family size decreases, or if you fail to recertify your plan each year, your loan servicer can capitalize up to 10% of the amount of your original loan balance. Still, this is less than the amount capitalized on other income-driven plans.

However, if you leave the plan, all of that outstanding interest will be capitalized. That can tack on several thousand dollars or more onto your loan, depending on how big your loan was when you started, how much your monthly payment is and how long you’ve been on the PAYE plan.

How to Qualify for Pay As You Earn

The Pay As You Earn repayment plan sounds like such a good thing that you might wonder why more people aren’t on it. It turns out, it’s actually one of the hardest income-driven repayment programs to qualify for. Here are the requirements you’ll need to meet to get on the plan:

• You’ll need to have a “partial financial hardship,” which means your monthly payments under the standard repayment plan are more than what they would be under the PAYE plan
• You must not have had any direct loans or Federal Family Education Loans (FFEL) before Oct. 1, 2007
• You must have received at least one direct loan after Oct. 1, 2011

How to Apply for Pay As You Earn

You can reach out to your loan servicer to apply for PAYE, or you can apply for PAYE and other IDR plans through the Department of Education’s website. It’ll take you about 10 minutes to apply and you’ll need a few pieces of information, such as your Federal Student Aid ID and information from your tax return. You can also use a handy tool in the application to automatically transfer your tax return information over

After you apply for PAYE, your loan servicer may put your loans into forbearance so you won’t have to make any payments while the company is considering your application, but keep in mind that interest will add up during this time. Once your loan servicer gives you the all-clear, you can start making your new monthly payment.

Pay As You Earn Benefits

The PAYE plan is one of the most popular income-driven repayment plans because it offers:

• Low payments. Your monthly payments are limited to either 10% of your discretionary income or what your payments would have been under the standard repayment plan everyone’s put on—whichever is lower. This is one of the smallest monthly payments among the IDR plans.
• Short forgiveness period. Your loans can be forgiven in 20 years. All of the other plans offer forgiveness in 25 years, except for income-based repayment for certain borrowers, and the Revised Pay As You Earn (REPAYE) plan, which offers loan forgiveness after 20 years if all your loans are from your undergrad education.
• Better help with interest. Unless you leave the plan, the amount of unpaid interest that can be added back onto your loan is limited to 10% of your original balance. With all other plans, all of your unpaid interest is added back to your balance.

Pay As You Earn Drawbacks

You also need to be aware of the downsides of the PAYE plan, because there are some big ones:

• More expensive over the long run. Even if you do qualify for loan forgiveness in 20 years, it’s possible that you’ll have paid more over the long run because you’ll be making payments for twice as long than if you’d been on a standard 10-year repayment plan.
• Must recertify every year. Your need to recertify your eligibility to stay on the PAYE plan every year. If you forget, unpaid interest will be capitalized (added) onto your loan balance so that it’s 10% larger than when you started, and your monthly payment will increase until it’s as large as it would have been if you were on the standard repayment plan.
• High potential for things to change. You can give birth to a child and send them off to college within the 20-year loan repayment time frame. This will affect your discretionary income, and ultimately, your monthly payment amount. In other words, there are a lot of unknowns and your financial situation could change so that it’s no longer worth it to be on the plan, but it could still cost you a lot of money (capitalized interest) to leave.
• Tax bomb. For many people, this is the biggest downside: any amount that’s forgiven will be treated as taxable income. This means you could be hit with a tax bill of several thousand dollars or more in the year that the loan is forgiven.

Alternatives to Pay As You Earn

The most important thing to know about PAYE is that it’s only one of several options available to you.

You can always refinance your federal student loan with a private lender. However, most financial experts would caution against that because you’re giving up a lot of built-in loan protections and options for affordable repayment.

The federal government also has three other IDR plans you can choose from:

• Revised Pay As You Earn (REPAYE). Your payment will also be 10% of your discretionary income. Unlike with PAYE, if you have any graduate student loans you’ll have to make payments for 25 years before your loans can be forgiven (as opposed to 20 years with PAYE).
• Income-Contingent Repayment (ICR). Your payment will be either 20% of your discretionary income or what it would have been based on a 12-year repayment schedule. Your loans can be forgiven after 25 years of payments.
• Income-Based Repayment (IBR). Your payment will be 15% of your discretionary income if you first borrowed before July 1, 2014, and you can receive forgiveness after 25 years. If you first borrowed on or after July 1, 2014, your payment will be 10% of your discretionary income and you can receive forgiveness after 20 years.

You can also choose from two other types of repayment plans:

• Graduated Repayment Plan. This plan scales your payments so that they’re smaller than normal at first, and then get larger than normal by the end. You’ll still finish paying them off in 10 years, however.
• Extended Repayment Plan. If you have at least $30,000 in direct loans you can sign up to stretch your payments out over 25 years.

If you’re considering PAYE or any other changes to the standard repayment plan, it’s good to run the numbers to see what effect it might have on your finances. There are many things to consider, but by focusing on how it’ll affect you in the short and long term you’ll be sure to find the best solution for you.