Income-based repayment, or IBR, can be a great option for recent college graduates who need some breathing room while getting started in a career. However, there are some real risks to it, especially for those who owe significant loan balances or are in career paths where the salary trajectory is fairly level. In these instances, the payments may never make enough of a dent on the loan principal to make a material difference in the balance, and the borrower could find themselves 20 years out with a large taxable loan forgiveness, despite paying substantial sums for 20 or 25 years.
IBR plans cap a borrower’s monthly payment at 10%, 15% or 20% of discretionary income. Discretionary income for student loan purposes is the difference between the borrower’s AGI and 1.5x poverty level for the borrower’s location and family size. (NerdWallet has a handy calculator here.) The payment is recalculated every year, so it will go up somewhat as the borrower’s income increases, but it will change if the borrower marries or has children since it’s based on family size. In addition, increasing retirement contributions lowers AGI, so it will lower loan payments as well.
IBR has many benefits, and it’s often the best way for recent college graduates to stay on top of their loans. But we had a client case recently that illustrates the perils of IBR.
In this case, the borrower graduated college about five years ago. His original loan balance was around $125,000 with multiple loans at interest rates of 6.55% to 7.65%. He recently got into an IBR plan because his debt had grown to over $160,000 since graduation. His monthly payment is just over $1,000, which is manageable on his salary of slightly over $100,000. However, he doesn’t foresee that his salary will grow exponentially over the coming years. Some quick calculations show that in his payment plan, he will pay over $125,000 in the coming 10 years but only decrease his outstanding balance to just over $150,000. (Yes, $125,000 in payments will only bring the balance down by $10,000; the other $115,000 goes to interest.) And after 20 years, he will have paid just over $250,000 and will still have a balance of over $129,000.
The good news: the $129,000 would be forgiven. The bad news? Loan forgiveness is taxable income. At current tax rates, $129,000 in added income would put him into the 32% tax bracket, meaning his loan forgiveness would cost him somewhere between $30,000-$40,000 in federal taxes. Which would be due in a lump sum on April 15, 2039.
What’s a borrower to do? If you are in IBR, check whether you’re actually paying down your loan balance. If not, you should figure out how to increase your payment to the point where you are– if not now, then at some point in the future. And even if you intend to go the debt forgiveness route, it’s important to chip away at your principal balance on an ongoing basis, whether by paying off smaller loans or by making lump sum payments against larger ones. Paying down extra principal won’t change your monthly payment; instead it will make your payment go further because you’ll be paying off more principal each month. And it will make the final bill for loans more palatable.
Remember, I’m talking about IBR here, not PSLF or other federal loan forgiveness programs. In those cases, loan forgiveness is tax-free, although based on news reports it isn’t something borrowers should count on.