How Income-Based Repayment Works

Will IBR prevent you from stepping up to a lifetime of student debt?
Will IBR prevent you from stepping up to a lifetime of student debt?
Ryan McVay/Lifesize/Thinkstock

Income-based repayment, or IBR, is an alternative method for paying back student loans that caps monthly payments at 15 percent of discretionary income. IBR is designed to relieve the crippling economic burden of student loan debt for millions of American households. The program was created by the College Cost Reduction and Access Act signed by President George W. Bush in 2007, but didn't go into effect until 2009. In 2011, President Barack Obama lowered the monthly payment cap to 10 percent for new borrowers [source: Liberto].

The average college student in the class of 2011 carried $26,600 in student loans, the highest student debt load on record [source: Cohn]. Although some college students took on student loans without fully understanding the terms, most considered their student loans an investment in long-term earning potential.

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After all, the numbers are clear: Workers with college degrees make more than those with only high-school diplomas. According to a 2010 study by the National Center for Education Statistics, workers ages 25 to 34 with college degrees made 50 percent more on average than people of the same age with only a high-school diploma [source: NCES]. Because of those numbers, most student borrowers count on getting a well-paying job that will easily cover the monthly loan payments.

But what happens if the job market dries up, as it has during the recession? Unfortunately for millions of recent college graduates, there aren't enough well-paying jobs to go around. In fact, 37.8 percent of recent college graduates are working jobs that don't even require a degree [source: Cohn]. The result is lower overall wages and higher default rates on student loans.

Of the 37 million Americans who carry outstanding student loan debt, 14.4 percent are in default, meaning 5.4 million borrowers are behind on at least one student loan payment [source: Federal Reserve Bank of New York]. That's the highest default rate in 14 years.

Under the standard payment plan for federal student loans, borrowers repay their debt at a low fixed interest rate over 10 years. Monthly payments are amortized to pay back both interest and principle by the end of those 10 years. A borrower with $50,000 and a 4 percent interest rate would pay over $500 a month, a huge sum if the best job you can find pays $12 an hour.

With income-based repayment, monthly payments are reduced according to your income and the size your household, and loan terms are stretched to 25 years. Any remaining debt after those 25 years can be canceled. The goal is to save the credit ratings of millions of borrowers by making their student loans more affordable.

On the next page, we'll explain the eligibility criteria for IBR and how to sign up for the alternative payment plan.

Qualifying for Income-Based Repayment

Income-based repayment can significantly reduce monthly payments on student loans, but you must meet certain eligibility criteria. Most importantly, IBR is only available for federal student loans, not private loans. If you received loans through your school by filling out a FAFSA (Free Application for Federal Student Aid), then you have a federal loan. If you received a loan from a bank or other institution, then you have a private loan.

Also, not all federal student loans are eligible for IBR. Parent PLUS Loans -- supplemental student loans made directly to parents of college students -- are not eligible. Neither are FFEL Consolidation Loans that include a Parent PLUS Loan. And here's a biggie: IBR cannot be used on any loan that is already in default, so keep making payments until you are accepted.

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Here is a full list of eligible loans:

  • Direct Subsidized Loans
  • Direct Unsubsidized Loans
  • Direct PLUS Loans made to graduate or professional students
  • Direct Consolidation Loans without underlying PLUS loans made to parents
  • Subsidized Federal Stafford Loans
  • Unsubsidized Federal Stafford Loans
  • FFEL PLUS Loans made to graduate or professional students
  • FFEL Consolidation Loans without underlying PLUS loans made to parents [source: Federal Student Aid]

If you don't know what kind of loan you have, or who services your loan, you can access that information at the National Student Loan Data System. You will need your Social Security number and your Federal Student Aid PIN. If you forgot your PIN, you can retrieve it from the Federal Student Aid PIN website.

Once you know what kind of loan you have, you need to plug your loan and income information into the IBR calculator. Here's how the calculator works. The calculator figures out the difference between your adjusted gross income (AGI) and 150 percent of the poverty income level for a family of your size in your state. The poverty line for a family of three in most states, for example, is $27,795. If you make $40,000 a year, then the difference is $12,205. Under the IBR, annual loan payments cannot be more than 15 percent of this difference, or $1,831, which breaks down to $153 a month [source: Federal Student Aid].

The IBR calculator will tell you if you qualify or not. Basically, if your IBR-calculated payment is less than the standard 10-year payment plan, then you qualify. Once you qualify, you will need to contact your loan servicer to start the application process. Remember, you can look up your loan servicer information on the National Student Loan Data System Web site.

Income-Based Repayment sounds like a great deal, but it does carry some hidden disadvantages. We'll discuss the advantages and disadvantages of IBR on the next page.

Advantages and Disadvantages of Income-Based Repayment

Do loan forgiveness programs make college more expensive?
Do loan forgiveness programs make college more expensive?
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There are many distinct benefits and a few potential drawbacks of choosing Income-Based Payment (IBR) over the standard loan repayment method. The biggest advantage is that monthly student loan payments under IBR are guaranteed to be lower than the standard plan, and in many cases significantly lower. Since the monthly payment amount cannot be more than 10 or 15 percent of your discretionary income it will always be affordable.

Another advantage of IBR concerns the interest on your loan. If you have a Direct Subsidized Loan or a Subsidized Federal Stafford Loan, then the government will pay any interest that isn't covered by your lowered monthly payment for up to three years. For example, if the interest portion of your loan payment is $300, but your IBR-calculated payment is only $200, then the government will pay the $100 difference for up to three consecutive years after you first qualify for IBR.

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The other significant advantage of IBR is that any loan balance remaining after 25 years will be canceled. If you take out a loan in 2012 or later, the balance is canceled after 20 years. Even better, if you work in public service -- for any federal, state or local government, or any approved nonprofit organization -- you are entitled to further help. Under the Public Service Loan Forgiveness Program, if you make 120 on-time loan payments (including IBR), the rest of your loan is canceled [source: Federal Student Aid].

One potential drawback of IBR is that by extending the term of the loan to 20 or 25 years, you could end up paying more interest than with a 10-year loan. That's how amortization works; the longer the loan, the more interest is paid over the life of the loan. Another drawback is the paperwork required. Since your IBR payments are pegged to your annual income, you need to submit earnings information to your loan servicer every year. If you fail to do so, the loan servicer has the right to raise your monthly payment amount back to the standard plan amount [source: Federal Student Aid]. Taxes are another consideration. Unless you work a public-service job, you will have to pay income tax on any loan amount forgiven after 20 or 25 years [source: FinAid]

Some critics argue that loan forgiveness programs like IBR could have the unintended effect of making college even more expensive. If students know that they won't have to spend more than 10 percent of disposable income on loans, and that their debt will be canceled after 20 years, then they will be more willing to pay higher tuitions and take on even more debt [source: Goldrick-Rab]. The effect of IBR on college tuition remains to be seen.

Author's Note: How Income-Based Repayment Works

When jobs dry up, there is a lot of hand-wringing over the value of a college education. What's the point of spending tens of thousands of dollars -- or piling on tens of thousands of dollars of debt -- if your college diploma can't get you more than a sales associate gig at Gap? The focus, however, should be on the long-term, both for individuals and the nation as a whole. For individuals, the numbers show that college graduates make much more money over the course of their careers compared to high school graduates. And for the nation, a better-educated populace drives innovation, fills the jobs of the future and raises the overall standard of living. That's why I applaud programs like Income-Based Repayment, which protect borrowers during downturns and allow payments to increase when earnings increase. It makes sense and it keeps higher education affordable.

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Sources

  • Cohn, Scott. NBCNews.com. "Student loan debt hits record high, study shows." Oct. 18, 2012 http://bottomline.nbcnews.com/_news/2012/10/18/14535163-student-loan-debt-hits-record-high-study-shows?lite
  • Federal Reserve Bank of New York. "Grading Student Loans." March 5, 2012 http://libertystreeteconomics.newyorkfed.org/2012/03/grading-student-loans.html
  • Federal Student Aid. "Income-Based Repayment Plan" [Accessed Oct. 23, 2012] http://studentaid.ed.gov/repay-loans/understand/plans/income-based
  • FinAid. "Taxibility of Student Loan Forgiveness" [Accessed Oct. 31, 2012] http://www.finaid.org/loans/forgivenesstaxability.phtml
  • Goldrick-Rab, Sara; and Kelchen, Robert J. The Chronicle of Higher Education. "Making Income-Based Repayment of Student Loans Cost-Effective." Oct. 18, 2012 http://chronicle.com/blogs/conversation/2012/10/18/making-income-based-repayment-of-student-loans-cost-effective/
  • Liberto, Jennifer. CNN Money. "Student loan payback gets White House attention." June 13, 2012 http://money.cnn.com/2012/06/13/pf/college/student-loans/
  • National Center for Education Statistics. The Condition of Education. "Annual Earnings of Young Adults." 2012. http://nces.ed.gov/programs/coe/index.asp