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Pay As You Earn: How It Works and Whom It’s Best For

Originally posted on NerdWallet by Brianna McGurran @briannamcscribe

The “Pay As You Earn” student loan repayment plan has requirements so specific they can make you dizzy. But don’t let them scare you away. If you meet the income guidelines and borrowed student loans in the time frame the plan calls for, it’s worth looking into.

PAYE, as the government refers to it, is best for grads who first borrowed federal student loans after Sept. 30, 2007, and took out an additional loan after Sept. 30, 2011. Your loan payments could be $0 on the plan if you have no earnings, making it a savvier option than postponing your payments when you’re unemployed.

“Sometimes it can be better than forbearance — for example, if you’re working toward Public Service Loan Forgiveness,” says Kristin Bastian, financial education manager for the Charleston, South Carolina, nonprofit Family Services Inc.

Take a look at the details so you can be sure PAYE is the best plan for you.

How it works

To prevent struggling grads from going into default, the government created a series of repayment options, called income-driven repayment plans, that let you contribute a percentage of your income toward your student loans. You’ll also have the rest of your balance forgiven if anything is left after 20 or 25 years of payments.

HISTORY

The most popular income-driven plan, called income-based repayment, went into effect in 2009.

It let all federal loan borrowers limit their student loan bills to 15% of their discretionary incomes and offered forgiveness after 25 years.

In 2012, the government made more generous standards available to recent graduates through PAYE. It capped payments at 10% of income instead of 15%, and promised forgiveness after 20 years instead of 25.

PAYE was specifically geared toward borrowers who graduated in 2012 — which explains the complex eligibility requirements. The grads most likely to take advantage of PAYE are those who started borrowing college loans in 2008 and graduated in 2012, and those who took out loans for grad school later on.

Revised Pay As You Earn, known as REPAYE, expanded PAYE to more borrowers in December 2015. But it introduced other restrictions that make it less desirable if you’re able to sign up for PAYE instead.

ELIGIBILITY

Beyond the eligibility restrictions on the year you borrowed loans, PAYE has two additional requirements:

  • Loan types: In order to repay your student loans on PAYE, they must be federal direct loans. You can consolidate Perkins loans or those made through the Federal Family Education Loan Program to make them qualify for PAYE. Perkins loans have forgiveness options, though, that you’ll lose if you consolidate them.
  • Income guidelines: Like income-based repayment, PAYE requires participants to show a partial financial hardship; your bill on PAYE must be less than what you’d owe on the standard 10-year plan. If you qualify, your monthly payment will be 10% of the difference between your monthly income and 150% of the poverty guideline. If your income goes up, your payment will never be higher than what you’d pay on the standard plan.

In practice

Say you’re a single college grad living in California. You earn $50,000 a year and owe $75,000 in federal direct loans at a 6.8% interest rate. On the standard plan, you’d pay $863 a month for 10 years. On PAYE, however, your monthly bill would be $270, and you’d have $52,746 forgiven after 20 years.

Forgiveness comes with a caveat, though: You’ll have to pay income tax on the amount forgiven, according to current IRS rules. That could mean a big tax bill several years from now.

“The benefit of this is that you have plenty of time to prepare for it,” says Ara Oghoorian, a financial planner at ACap Asset Management in Encino, California, whose clients work mostly in health care. Consider saving some money to prepare for your tax bill if you expect to have a big balance forgiven.

Use Federal Student Aid’s Repayment Estimator tool to see what you’d owe each month and how much would be forgiven on PAYE.

Whom it’s best for

PAYE has more restrictive eligibility requirements than income-based repayment and REPAYE. But if you’re a candidate for the PAYE plan, it will give you the most generous monthly bill discount and additional perks.

GRADS WHO BORROWED LOANS ON QUALIFYING DATES

PAYE isn’t your only option if you first took out a federal student loan after Sept. 30, 2007, and another after Sept. 30, 2011, but it’ll give you a lower bill than income-based repayment. And while REPAYE will charge you the same amount to start, there’s no limit to how high your monthly payment could rise if you make more money. You must recertify your income every year and whenever your income changes.

You also have to report your spouse’s income on your REPAYE application, even if you file taxes separately. PAYE doesn’t have that requirement, so your payments will be based on your own income if you file as a single person or separately from your spouse.

GRADS WHO WORK IN PUBLIC SERVICE

Twenty years is a long time to repay your loans, even when you know they’ll be forgiven at the end. The federal Public Service Loan Forgiveness program allows nonprofit or government employees to receive forgiveness after they make 120 monthly payments, cutting that timeline in half if you make consecutive qualifying payments for 10 years.

You’ll get the biggest benefit from the program if you repay loans through an income-driven plan like PAYE. Plus, your forgiven balance won’t get taxed on the Public Service Loan Forgiveness program, the way it would on PAYE alone.

“That’s a huge variable that people need to factor in,” Oghoorian says.

» MORE: Guide to student loan forgiveness

How to apply

You can apply for PAYE for free through your student loan servicer, or you can fill out an Income-Driven Repayment Plan Request form directly on studentloans.gov. You’ll have the option to choose which income-driven plan you want, or you can check a box requesting the government pick the plan that will give you the lowest monthly payment.

If your circumstances are complex and you want to talk through your options with a professional, student loan counseling is available through nonprofits like the National Foundation for Credit Counseling. The organization can pair you up with a certified student loan counselor in your area. You’ll pay a fee for the service, generally around $200, but you’ll work with a professional who’s been vetted by the NFCC.

“They’re only sending those consumers to member agencies who have a licensed student loan counselor on staff,” Bastian says.

Brianna McGurran is a staff writer at NerdWallet. Email:bmcgurran@nerdwallet.com. Twitter: @briannamcscribe.