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Q: What are the disadvantages to income-based repayment?

May 15, 2020

There are 3 major disadvantages to income-based repayment:

  1. You’ll be in student loan debt longer
  2. You’ll pay more in interest
  3. You’ll get hit with a tax bill at the end of the plan.

Two other minor disadvantages are that you have to apply for an IBR plan each year and your monthly payments could be a lot more than if you paid your loans off in 10 years.

#1 You’ll stay in student loan debt longer

The income-based repayment plan is one of 4 loan repayment plans based on your income the Department of Education offers:

  • Income-Based Repayment (IBR)
  • Revised Pay As You Earn (REPAYE)
  • Pay As You Earn (PAYE)
  • Income-Contingent Repayment (ICR)

Each repayment option limits your monthly payment amount to a percentage of your discretionary income.

Discretionary income is the difference between your adjusted gross income (AGI) and your family size.

Related: How AGI Affects You Get Lower Monthly Loan Payments

In exchange for offering the lower monthly payment, the government stretches your student loan repayment from 10 years to 20 to 25 years.

As a result, you may end up paying your student loans at the same time you’re trying to help pay your children’s education debt.

#2 You’ll pay more in interest

The longer you have your federal loans, the longer time your interest has to accrue. And the more time your interest has to accrue, the more you’ll pay in interest.

Federal student loans are particularly brutal when it comes to interest: they start accruing interest from day one.

And once they start accruing interest, they don’t stop.

Related: Why You Should Choose the Income-Based Repayment

On top of that, federal student loan interest is calculated on a daily basis. Depending on your interest rate, your loan balance can double or triple while you’re in the IBR plan.

So what should you do? Stay in the IBR plan or pay your loans off faster?

The answer depends on a host of factors:

  • Your age
  • Loan balance
  • Annual income
  • Retirement/Savings
  • Family size

Typically, my advice is that the larger your loan balance and the smaller your income and retirement/savings, the more inclined you should be to stay in the income-based repayment plan.

#3 You may have a large tax bill

At the end of the income-based repayment plan, your entire loan balance will be forgiven without limit.

While getting rid of your student loan debt sounds great, the problem is that you’ll be swapping one debt for another.

The IRS will treat the forgiven balance as taxable income when you file your next income tax return.

Public Service Loan Forgiveness

While loan forgiveness under the IBR plan is treated as taxable income, the loan amount that’s forgiven under the Public Service Loan Forgiveness program is not treated as taxable income.

Under current tax law, you can avoid paying taxes on the forgiven balance by applying to have the balance excluded from your income.

FAQs

  • Will income-based repayment hurt my credit score?

    Income-based repayment will not hurt your credit score. In fact, just the opposite may occur: your credit score may likely improve. The IBR plan allows you to get a monthly student loan payment based on your income, which should free up money to pay your other debts.

  • Can you make too much money for income-based repayment?

    The income-based repayment plan requires you have a partial financial hardship to enter into the plan. A partial financial hardship is when your monthly payments under the IBR plan are cheaper than your payments would be under the Standard Repayment plan. So if your income is high, you may not be able to qualify for the IBR plan. But if your income increases after you’re already in the IBR plan and you no longer have a partial financial hardship, you can stay in the IBR plan.

  • How long can you be on the income-based repayment?

    You can be on the income-based repayment plan until you qualify for loan forgiveness, which occurs after 20 to 25 years of payments.

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