When it comes to Federal income driven repayment ("IDR") plans for student loans, it seems that everyone from ‘Financial experts’ to your peers have differing opinions about them. Generally, we've been hearing two common viewpoints, either they are the greatest repayment plan introduced or they are a toxic product that will lead to another financial crisis.
At FitBUX, we have a different opinion. We believe that all financial products have a purpose. If used for that purpose, the financial product is extremely useful. If misused, the result can be costly.
Bloomberg recently highlighted a costly and easily avoidable mistake many people make when using a Federal IDR plan. In this article, we dive deeper into that mistake.
However, before we do I want to provide you with a little background on Federal IDR plans:
- There are five Federal IDR plans: income based repayment (IBR), income based repayment for new borrowers, pay as you earn (PAYE), revised pay as you earn (REPAYE), and income contingent repayment (ICR).
- The terms on these programs range from 20 to 25 years. Repayment is based as a percentage of your adjusted income and is capped between 10% and 15%.
- If your monthly payment is not large enough to cover the monthly interest charge, the amount not paid accrues (this is called accrued interest) and is added to the principal loan balance. In most cases, the accrued interest does not accrue more interest i.e. there is no compounding affect.
- At the end of the term the remaining loan balance and any accrued interest is forgiven but the amount is taxable as income.
- Borrowers are required to share their earnings information with their loan servicer annually.
The Costly Income Driven Repayment Plan Mistake
The costly and easily avoidable mistake centers around the last bullet point above. If you do not submit you earnings on time, your monthly payment will increase. The amount of increase depends on which IDR plan you are on. However, that is not the critical part. If you do not submit your earnings on time your interest may be capitalized. In plain English, this means the interest that has accrued will now be charged interest. In other words, you will be charged interest on top of interest.
This is a costly mistake. According to the Bloomberg article referenced above, almost 24% of borrowers on a Federal IDR plan fall off the plan simply because they do not submit their earnings.
To illustrate the cost of this mistake I will use this simplified example:
- You owe $100,000 at the time you go onto a Federal IDR plan.
- The interest rate on the loan is 6.0%.
- Your Federal IDR plan forgives the balance and accrued interest after 20 years, at which time you will owe taxes on the amount forgiven.
- The monthly payment under the Federal IDR plan is $300 per month. For simplicity, we will assume that your income does not grow during the 20 years. Therefore, your monthly payment remains the same throughout.
A loan of $100,000 at a 6.0% interest rate has interest costs of $500 per month. As stated in the assumptions above, the monthly payment on our Federal IDR plan is $300 per month. This means we are deferring $200 per month in unpaid interest.
In this scenario, we assume the individual sends their annual earnings to the loan servicer each year and the loan is forgiven in 20 years. At that time the amount forgiven is $148,000 ($100,000 for the loan amount plus $48,000 in accrued interest).
At a 35% tax rate, the individual in this scenario would pay $51,800 in taxes when the loan is forgiven since forgiven loan amounts are treated as taxable income.
In this scenario, we assume the same assumptions as discussed above. However, let's assume that in year 10, the individual does not submit his annual earnings to the loan servicer. At that time he would have accrued $24,000 in interest, which then becomes capitalized. That means the balance of the loan is now $124,000 and the full amount is charged interest. At a 6.0% interest rate, the monthly interest would be $620.
We will assume that the individual corrected this mistake within a month and went back onto a Federal IDR plan. Therefore, the required monthly payment remains at $300, but the individual now defers $320 in unpaid interest per month.
At the end of the remaining 10 years, the amount forgiven would be $162,400 ($100,000 for the loan amount, plus $24,000 of interest for first 10 years, plus $38,400 of interest for the last 10 years). The resulting tax payment at a 35% tax rate would be $56,840, or $5,040 more than in Scenario 1 or almost 10% more.
What To Do
Although we assumed very simple assumptions in our example above, the moral of this story is that you must remember to file your annual earnings with your loan servicer.
FitBUX recently launched a new technology to help you determine whether going on a Federal IDR plan or paying down your loans is the right decision for you. If you would like to be part of our trial program click here.