Debt & Liability Planning

Selecting Income-Driven Repayment (IDR) Plans To Manage Student Loan Obligations

Income-Driven student loan repayment plans, which started with Income-Contingent Repayment (ICR) in 1993, can make monthly repayment substantially more affordable for many borrowers by limiting student loan payments to no more than a certain percentage of income. However, when considering any of the five Income-Driven Repayment (IDR) plans, it’s critical to think not only of how borrowers may manage the monthly repayment costs but also of the long-term income trajectory of the borrower. Since payments are based on income, those who expect high future earnings may not benefit from using an IDR plan; because payments increase proportionately with income levels (and depending on the interest rate(s) of the loans being paid off), the borrower may or may not be better off maintaining lower monthly payments than paying the loan off quickly with higher payments. Which makes the decision to choose an IDR plan potentially complex, especially since many repayment plans for Federal student loans not only limit monthly payments relative to income but may also actually trigger forgiveness of the loan balance after a certain number of years.

Accordingly, the first line of action for borrowers tackling student loan debt and its potential repayment strategies is to identify the specific goal: to pay the loan(s) off in full as quickly as possible and minimize the interest expense along the way, or to seek loan forgiveness and minimize total payments along the way (in order to maximize the amount forgiven at the end of the forgiveness period). Once the objective is clear, planners can explore the repayment options available.

For those seeking the path of loan forgiveness, IDR plans that limit current payment obligations are often preferable, as even if they lead to the loans negatively amortizing (as the interest accrual on the student loans may significantly outpace the required payment if a borrower has a relatively low income), doing so simply maximizes forgiveness in the end. On the other hand, debt forgiveness may not be best; if the borrower does stay on that IDR plan all the way through forgiveness (typically 20 or 25 years), the forgiven amounts may be treated as income for tax purposes (which for some borrowers, could actually bring the total cost to far higher than what they would have paid had they actually paid down their loan balance to $0!).

Ultimately, the key point is that repayment strategies should be chosen carefully, as the desire to manage household cash-flow often entails minimizing payments that maximize forgiveness, but the income tax consequences of forgiveness and rising repayment obligations as income grows can sometimes result in higher total borrowing cost than simply paying off the loan as quickly as possible!