5 things you should know before applying for an income-based repayment plan

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In a Nutshell

Before you opt for an income-based repayment plan to help you pay down your student loan debt, it's crucial to understand the consequences that can come with these types of payment plans.

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If you’re having trouble keeping up with your federal student loan payments, one of the income-based repayment plans—often referred to as income-driven plans—can be a welcome reprieve.

Under these repayment plans, student loan borrowers can base their monthly payments on a percentage of their income. In some limited cases, payments could amount to zero dollars. Yep, you read that correctly.

While an income-driven plan may seem like an easy way to tackle your federal student loan payments, there are five things you should know before applying:

  1. You may pay more in interest.
  2. You may have to qualify for the plan first.
  3. You have to re-certify each year.
  4. Your loans could be forgiven after a period of time… but with one big consequence.
  5. You could end up neglecting other financial goals.

1. You may pay more in interest.

Currently, there are four income-driven plans: the Revised Pay As You Earn (REPAYE) Repayment Plan, Pay As You Earn (PAYE) Repayment Plan, Income-Based Repayment (IBR) Plan and Income-Contingent Repayment (ICR) Plan.

Under these plans, student loan borrowers generally have monthly payments set at 10 to 20 percent of their discretionary income for a period of 20 to 25 years.

While using a small portion of your income and extending your repayment period can ease the strain on your budget, you may end up paying more in interest in the long run. In some cases, significantly more. If an income-driven plan is what you need to remain in good standing with your debt, it can be a useful option. Just understand that you may end up paying a lot more than your original balance.

2. You may have to qualify for the plan first.

Not all income-driven plans are created equal. Some of the plans require that the borrower qualify for the plan first, whereas other plans may have more flexibility.

For example, you must qualify first in order to choose the IBR Plan or the PAYE Plan. Typically, you’ll be eligible for these plans if your student loan balance exceeds your annual salary. In addition, to qualify for the PAYE plan, you must be a new borrower and have received your loan disbursement on or after Oct. 1, 2011. You’ll have to submit income information in order to qualify and get approved for these plans.

The other two income-driven plans — the ICR Plan and REPAYE Plan — are available to anyone with eligible student loans.

Since you may not qualify for all of the income-driven plans, it’s important to research and decide which one is the right fit for you.

3. You have to re-certify each year.

Let’s say you get on an income-driven plan and your payments are significantly lowered. You may think you can finally breathe a sigh of relief, afford your payments and go on with your life. But not so fast.

“Borrowers must certify their income every year (to continue on the plan),” says student loan expert Heather Jarvis. According to the Federal Student Aid website, you must provide your loan servicer with information regarding your income and family size each year, even if no change has been made.

According to a 2015 report by the Department of Education, nearly 57 percent of borrowers missed their deadline and didn’t recertify on time.

You may think this isn’t such a big deal, but it could have negative consequences if you don’t act in a timely manner. According to the Consumer Financial Protection Bureau, not recertifying could mean you lose your income-based status, and your payments may go back to being unaffordable until you submit your information. If you want to avoid a sudden increase in your monthly payments, make sure you take action each year to recertify. Your loan servicer should send you a reminder when it’s time to recertify.

4. Your loans could be forgiven after a period of time… but with one big consequence.

One of the most attractive advantages about income-driven plans is that your remaining balance could be forgiven after you make consistent, qualified payments for a period of up to 25 years. This may seem like the easy way out of your debt, but there could be one big consequence that can come as a huge surprise. Your forgiven student loans, under current tax law, may be considered taxable income.

“If the debt balance isn’t eliminated by the end of the repayment period, the remaining balance will be written off by the creditor, and the debtor will receive a Form 1099-C, which is considered taxable income,” says Eric J. Nisall, accountant and founder of AccountLancer. If you receive a 1099-C, so will the IRS, and you must report it on your tax return.

This means that, depending on the amount you get forgiven, your tax bracket and where you live, you could end up with a significant tax bill. While your tax bill could ultimately be less than you borrowed, it may still end up being a cause of financial stress.

5. You could end up neglecting other financial goals.

Even though you’ll likely have a relatively low and manageable student loan payment on an income-driven plan, paying your student loans for that long could cause you to neglect other financial goals.

Under the Standard Repayment Plan, you could pay off your debt in 10 years and then be done, giving you more time to boost your savings and investments. If you’re making student loan payments for a long period of time, you may neglect saving for retirement. Many borrowers will be in their 40s by the time their loans are forgiven.

If you opt for an income-driven plan, consider your options for saving and investing so that by the time you are done with repayment, you aren’t starting from scratch.

Bottom Line

Switching to an income-driven repayment plan can be a great way to maintain your good standing on your student loans, as it often makes payments more budget-friendly.

But before you opt for one of these plans and work to get your loans forgiven, it’s crucial to understand the consequences that can come with an income-driven plan. It could help you out now, but may hurt in the long run.

“Each income-driven plan has pros and cons. Consider the details carefully,” says Jarvis.