Amanda L. Grossman is a personal finance writer and the creator of FrugalConfessions.com. In this post, we asked her to help explain the new Pay As You Earn Program recently launched by the Obama administration.
I remember having a financial discussion with my uncle one day over lunch. In that conversation he told me that he paid the last of his student loans off at the ripe age of 28. He had never opened up much about his financial past, though I knew he had been a writer/cartoonist/online entrepreneur since college and that sometimes he struggled to make ends meet. Still, I remember looking oddly at him from my 21-year old face because I was wondering how on earth it was that someone could hang onto their student loans until their late twenties.
Several years later, I got the opportunity to answer my own question.
I graduated from a four-year liberal arts college in 2005. Along with a diploma, great contacts, and an amazing education, I left with around $36,000 in debt. Considering the fact that tuition, room, and board at my college was $32,000 per year, I knew that I had come away with a bargain. But this did not ease the knot in my gut that had formed during my financial aid exit interview.
So how old was I when I paid off the last of my student loans? Two months shy of my 28th birthday, just like my uncle!
I was fortunate in that I had a steady job for most of the time between graduating college and paying off the last of my loans. But even with steady employment and a low cost of living, it took me a solid five years to do so. This made me wonder: how do people afford to repay higher college loan debts than my own if they are struggling to find a job or if their level of income doesn’t match their loan payments?
A recently launched program called the Pay As You Earn (PAYE) program provides hope to some student loan borrowers who are facing financial hardship. Below, I’ll explain how this program works and who is eligible for it:
How Does the Pay As You Earn Program Work?
At its heart, the Pay As You Earn Program is intended to be a life-preserver for those who are facing difficult financial circumstances and who therefore are having a hard time paying off their student loan(s). The program allows you to pay only a percentage of your monthly income rather than the usual minimum monthly payment.
It’s true that paying federal student loans as a percentage of income earned is not a new concept – the Income-Based Repayment Plan (IBR) and the Income-Contingent Repayment Plan (ICR) are two long-standing similar programs.
However, the Pay As You Earn Program offers more leeway on federal student loan repayments than either of these two existing plans. In an attempt to allow some breathing room, the Pay As You Earn Program gives the chance to repay loans made under the Direct Loan Program based on ability. A person’s “ability” to pay is based on their adjusted gross income (AGI) and family size.
The formula that the government uses to determine the monthly payment expected under this program is 10% of the difference between your AGI and 150% of the Poverty Guideline for your family size. If, based on your circumstances, loan amount, and interest rate, your calculated monthly payment does not cover the interest accrued, then the government will pay your unpaid accrued interest on subsidized loans for up to three consecutive years from the date repayment begins.
Also, any remaining student loan balances after 20 years of qualifying payments will be forgiven.
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Who Is Eligible for the Pay As You Earn Program?
Your eligibility depends on whether or not you have loans under the Federal Direct Loan Program, whether or not you are considered a “new borrower” (for the purposes of this program, a “new borrower” is defined as someone who both did not owe any money on any federal student loans as of October 1, 2007, and also received a disbursement of a Direct Loan on or after October 1, 2011), and being able to demonstrate partial financial hardship.
You have a partial financial hardship if the monthly amount you would be required to pay on your eligible federal student loans under a 10-year Standard Repayment Plan is higher than the monthly amount you would be required to repay under Pay As You Earn.
But how do you know if you have a financial hardship? Well, if the amount you’d be paying with a Standard Repayment Plan is higher than what you’d be required to pay under Pay As You Earn, then you would be eligible. So yes, it all comes down to calculations.
Financial Considerations to Make
There are some very attractive aspects of this program. First and foremost, the program will allow some student loan borrowers to make ends meet by reducing their monthly payment. Other than that, ones that, attractive aspects that jump out to me specifically are: the ability to potentially have the government subsidize interest after graduating college, that fact that capitalization of interest is limited to 10 percent of the original balance, and that your loans will be forgiven after 20 years of payments (which will reduce the number of people having to pay off student loans off in retirement).
Smaller monthly payments also mean that your cash flow will increase. However, there are things you should consider before applying for this program:
- Any of the debt forgiven in an income-based repayment program, including Pay As You Earn, is taxable as income.
- The principle of the loan is not forgiven before 20 years, and so by making lower monthly payments you are prolonging the repayment of the loan. This means that the amount of interest paid will be substantially higher over the life of a 20-year loan than over the life of a 10-year loan (the standard repayment period). Student loan interest may be deductible; however, the deduction will not make up for the amount of extra interest you will be paying over the extended period of time.
- You must file new documentation of earnings and family size every year. This means your monthly payment could change, and you could even lose eligibility depending on natural income changes over the progression of a career (a lot can happen in 20 years!).
- Your other student loans will be on their own repayment plan, as they are not part of this program. So you could be looking at several payments to make each month.
- Your account must be in good standing in order to qualify for this program. In other words, if you have already defaulted, this may not be the option for you.
How to Apply for the Pay As You Earn Program
If you wish to apply for the Pay As You Earn Program, first get in touch with your loan servicer as they can answer any questions that you may have as well as help you to figure out if this is a good solution for you.
If you then want to apply, you will need to complete the electronic Income-Based (IBR)/Pay As You Earn/Income-Contingent (ICR) Repayment Plan Request. You will need a PIN, a copy of last year’s tax returns (fill out IRS Form 4506-T to request a transcript), and any other documents your lender may request.
Good luck, and let us know in the comments below if you have any questions!
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