A new way to pay off student loans

This post comes from Jim Wang at partner blog Bargaineering.

A few weeks ago I asked newsletter subscribers to e-mail me about the things that concerned them. Many readers told me that the cost of higher education and their student loans were some of the things on their minds.

• Bing: Why does college cost so much?

A few years ago, I wrote about how my sister took advantage of a student loan forgiveness program for teachers. It’s a great program if you can participate because it helps the (former) student and it helps society as a whole by putting incentives and compensation more in line with the work performed. Today, I wanted to discuss the income-based repayment plan created by the College Cost Reduction and Access Act of 2007. It became available on July 1.

Income-based repayment, or IBR, is a system in which monthly payments to federal student loans, such as Stafford, Grad Plus and consolidation loans (but not Perkins or Parent PLUS loans), are capped at 15% of your monthly discretionary income. Discretionary income is defined as the difference between your adjusted gross income from the prior year and 150% of the federal poverty line for your family and state.

Calculating discretionary income. Let’s say you are in a family of one (single), you live in one of the 48 contiguous states, and your adjusted gross income is $40,000 a year.

According to the 2009 poverty guidelines, the guideline for you is $10,830. You subtract $16,245 (150% of the guideline) from $40,000 to arrive at $23,755. Then, 15% of $23,755 is $3,563.25, or $296.94 per month.

What if your income changes significantly? The equation uses last year’s AGI, but your income this year might be lower because you lost your job or took a pay cut. Obtain an OMB-approved IBR Plan Alternative Documentation of Income form from your lender for a more accurate calculation.

Who qualifies? There are no other qualification rules outside of the types of loans and your income. As long as you have a Stafford, Grad PLUS, or federal consolidation loan, you qualify. Perkins loans are not included but if you have a Perkins loan consolidated into a federal consolidation loan, it qualifies. Parent PLUS loans do not qualify.

Here’s a table from the Federal Student Aid Web site showing example payment amounts matched with family size and annual income, to give you an idea of whether IBR is right for you:

Unpaid interest waived. Your IBR calculated payment may be less than the interest that accrues on your loan. With subsidized Stafford loans, the extra interest is waived for the first three years of income-based repayment. On other loans, and Stafford loans after three years, the interest is still accrued and capitalized on a status change. You can always pay more than the IBR minimum payment.

Loan forgiveness after 25 years. You would think that the lowered payments would simply mean you’re paying longer, but the bill has provisions that forgive the debt after 25 years. After 25 years of payments, even if you haven’t fully paid off the debt, the loan is forgiven and the debt is discharged. The discharged amount will be considered as taxable income in the year it’s discharged, as is common with forgiven loans.

Are there disadvantages? Yes.

• You will pay more in interest. Because your payments are capped, you will accrue more interest on your loan as the years pass, especially if your payment is less than the interest each month.
• More documentation each year. Because the payment is based on your income, you’ll have to reset the payment amount each year and file documentation showing how much you earned and your family size.

How to apply. If you’re thinking about IBR and wondering how you can participate in the program, talk to your current lender.

That’s income-based repayment for student loans in a nutshell. While this program seems like a benefit to students, it actually may hurt future students. If the price of college is too high, the market should react by demanding less college (fewer students choosing to attend). By having this program, with the government taking on part of the burden, we’ve inflated demand because families will have to pay less in the long run. The economics of the situation sure are ugly, huh?

Related reading at Bargaineering:

• 2010 federal income tax brackets
• Bank CD rates
• How to pick the best credit card