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Pay As You Earn: What You Need to Know

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Introduced in 2012, Pay As You Earn is one of four income-driven repayment plans for student loans that can lower your monthly payments. In fact, it caps payments at 10% of your discretionary income while extending your terms to 20 years. If you still have a balance after this time, it will be forgiven.

But with four income-driven plans to choose from, is the PAYE plan the best option for you? Read on to find out.

Pay As You Earn repayment plan: How it works

When your loans are on the standard repayment plan, you pay enough each month to get out of debt in 10 years. But if you owe a lot in student loans and/or have a limited income, you might struggle to afford these payments.

That’s where an income-driven repayment plan like PAYE can help. When you put your student loans on PAYE, you’ll pay 10% of your discretionary income (which is the difference between your gross income and 150% of the poverty guideline for your family size).

Let’s say, for example, your discretionary income is $2,000 per month. On PAYE, your monthly student loan payment will be $200. What’s more, your monthly payment will never be more than what it would be on the standard 10-year plan.

Along with capping your payment, the PAYE plan also sets your repayment term to 20 years. If you still have a balance at the end of this term, it will be forgiven. However, the forgiven amount will be treated as taxable income, so you’ll still have one final bill to pay on your loans before you’re totally debt-free.

Which loans are eligible for PAYE?

Pretty much all federal student loans are eligible for PAYE, with the exception of parent PLUS loans, FFEL parent loans, or any consolidation loans that contain loans made to parents. Eligible loans include,

  • Direct subsidized loans
  • Direct unsubsidized loans
  • Direct PLUS loans made to graduate students
  • Subsidized FFEL loans, if consolidated and not made to parents
  • Unsubsidized FFEL loans, if consolidated and not made to parents
  • FFEL PLUS loans made to graduate students, if consolidated
  • Perkins loans, if consolidated

There is another eligibility requirement to be aware of. To qualify for PAYE, you must have received a loan on or after Oct. 1, 2007 and received a disbursement of a Direct loan on or after Oct. 1, 2011.

Pros of Pay As You Earn for student loans

Here are some of the biggest benefits of the PAYE plan.

Caps your monthly payment

PAYE limits your student loan payments to 10% of your income, one of the lowest calculations of any income-driven repayment plan. What’s more, you’ll never pay more than you would on the standard plan.

Offers student loan forgiveness after 20 years

While some income-driven plans extend your terms to 25 years, PAYE has one of the lowest term limits at 20 years. This term applies regardless of whether you took out your loans for your undergraduate or graduate education. At the end, any remaining balance should get discharged.

Only takes one spouse’s income into account if you file separately

Since income-driven plans base your student loan payments on income, you might only want to take your income into account and not your spouse’s. While the Revised Pay As You Earn (REPAYE) plan always considers both spouses’ incomes, the PAYE plan will only use yours if you file separately from your spouse.

Has an interest subsidy

If you get on PAYE, you can enjoy an interest subsidy on your federal subsidized loans. On PAYE, the government covers 100% of the unpaid interest on your subsidized loans during your first three years of repayment. However, it doesn’t help with the interest on unsubsidized loans.

Limits capitalized interest

A final perk of the PAYE plan is the limit it places on capitalized interest. When interest capitalizes, it gets added on to your principal amount. As a result, you end up paying interest on top of interest.

There are a few events that trigger interest capitalization, and one is switching repayment plans. So you don’t want to change your repayment plan too often, as this could make your debt more expensive.

If you do end up leaving PAYE, though, the amount of capitalized interest will be limited to 10% of your original balance when you started the PAYE plan. Even if your loans have accrued more interest than that, it won’t get added on to your principal.

Cons of Pay As You Earn for student loans

Along with the benefits of PAYE, there are some potential downsides.

Stricter eligibility requirements than other plans

While PAYE has several useful benefits for borrowers, it has some of the strictest eligibility requirements of any income-driven repayment plan. As mentioned, you need to have borrowed loans on or after Oct. 1, 2007 and had a Direct loan disbursement on or after Oct. 1, 2011.

If you borrowed loans before that time, you might be able to make them eligible by consolidating with a Direct consolidation loan. What’s more, you also need to prove partial financial hardship to qualify for PAYE.

Basically, your loan servicer will look at your income and family size, along with your loan amount, to see if you meet the criteria. You’ll need to have a relatively low income compared to your debt amount.

Plus, your PAYE payments need to be less than what you’d pay on the standard 10-year plan. To stay on PAYE, you’ll need to re-certify your information on an annual basis. If you’re not sure if you’d qualify, make sure to reach out to your loan servicer to discuss your individual situation.

Worse interest subsidy than REPAYE

While PAYE has a helpful interest subsidy for subsidized loans, another income-driven repayment plan, REPAYE, has an even better one. As mentioned, the Pay As You Earn repayment plan will cover interest on subsidized loans for the first three years.

But the REPAYE plan covers 100% of interest on subsidized loans for three years and 50% of interest after three years. Plus, it covers 50% of interest on unsubsidized loans throughout your period of repayment.

If you’re looking for the best interest subsidy, REPAYE might be the better choice.

Longer repayment term means higher interest costs

This final disadvantage isn’t specific to PAYE; it applies to all income-driven repayment plans. Since they extend your loan terms to 20 or 25 years, you end up in debt for longer and pay a lot more interest overall.

Let’s say, for example, you owe $40,000 at a 5.05% rate. After 10 years, you’d pay $11,029 in interest. But after 20 years, you’ll pay $23,621. And after 25 years, you’ll pay $30,501.

To avoid increasing interest costs, stick with the 10-year plan if possible. Only if you can’t afford it should you consider applying for income-driven repayment.

Who is the PAYE plan best for?

Now that you’ve read over the pros and cons, you might have a good idea of whether the PAYE plan makes sense for you. A few borrowers who it could work well for include,

  • Borrowers with graduate school loans, since it extends your term to 20 years whereas a plan like REPAYE would extend it to 25 years
  • Married borrowers who want to file separately so only one income gets taken into account
  • Borrowers with low income who meet the partial financial hardship requirement (and don’t expect their income to increase significantly over time)

If you’re exploring income-driven repayment plans, you probably want to choose the one that will get you the lowest student loan payment. Your loan servicer should help you crunch the numbers to figure out the right plan for you.

Click here to compare all four income-driven repayment plans for student loans.  

How to apply for Pay As You Earn

If you decide PAYE is right for you, you can apply online at StudentAid.gov. Here are the steps in a nutshell:

  • Log in to your Federal Student Aid account with your FSA ID.
  • Choose Income-Driven Repayment Plan Request. You’ll need to provide documentation to prove your income.
  • The form should select the plan with the lowest monthly payment based on your information, or you can specifically request PAYE. Again, speak with your loan servicer if you need help navigating the process.

While you’re waiting for approval, your loan servicer might place your loans into forbearance. This means that you won’t be required to make any payments, but interest will continue to accrue.

Other ways to adjust your student loan payments

While the PAYE plan can lower your student loan payments, it’s not the only option for federal student loans. Some other non-standard plans include,

  • Revised Pay As You Earn
  • Income-Based Repayment
  • Income-Contingent Repayment
  • Extended repayment
  • Graduated repayment (this one lowers your payments in the beginning and raises them over time so you still pay off your loans in 10 years).

Another option to consider is refinancing your student loans for new terms. Not only can you adjust monthly payments through refinancing, but you could also get a better interest, which could save you money.

But note that refinancing federal student loans turns them private, so they’ll no longer be eligible for PAYE or other federal plans.

Ultimately, it’s important to explore your options, along with the pros and cons of each, so you can make the best choice for your unique financial situation.

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