December 1, 2013

Student Loan IBR Can Cost You More In the End

Income Based Repayment (IBR) for student loans can be a helpful relief for many student loan borrowers.   If you have a significant amount of debt and your pay is relatively low then it can be a challenge to make your student loan payments along with paying all your other bills.   IBR lets you make a reduced payment based on your income level relative to your loan balance.  On top of that if you make IBR payments for 25 years then your loan balance can be forgiven. 

But IBR isn't always best for you financially.   One big gotcha about the IBR is that your future income is likely to increase and your future payments will be higher.  THis effect can have a gradual accumulating impact that raises your IBR payments.   Plus if you're making IBR payments for 25 years this extends your loan repayment over many more years past the standard 10 year repayment term.

Lets say you've got $50,000 in loans at 6.8% and you currently make $30,000 a year income.

With normal repayment terms you'd pay $575 a month for 10 years.  Your total payments would be $69,048 with $19,048 of interest.   If you went with the extended 25 year term under full payments you'd have a $347 monthly payment resulting in $104,108 total payments and $54,108 in interest.

If you sign up for IBR you would start with a $160 monthly payment.  Thats based on a single person making $30,000 income and no dependents.   Doesn't seem like a bad deal.   Now next year lets assume that you get a 3% income increase and then end up making $30,900.  For that next year your IBR payment would increase to $170 a month.  Then in the 3rd year another 3% raise would result in income of $31,827 and payments of $180.   And so forth over the years as your income goes up your payments would go up as well.   If you got 3% annual raises for 25 years then you'd end up with income of $60,984 and loan payments of $550.    Using this assumption of 3% annual raises your total IBR payments would end up $99,240.   This is still a little cheaper than the $104,108 you'd make with the normal 25 year payments but not by much.  

Now also with IBR at the end of 25 years you'd also qualify for forgiveness of the loan.   Because your payments were relatively low most of those 25 years you would actually accumulate principal for many years since you aren't paying enough to cover the interest.   During the first 3 years of IBR the government will waive any interest that your payments don't cover.   But after those 3 years interest starts to accumulate and can increase your principal.   At the end of 25 years in this example I figure you'd still owe about $43,000 on the loan.   That amount will be forgiven BUT another big gotcha with IBR is that you may owe income taxes on that forgiven balance.   If you're in the 15% tax bracket then taxes on $43,000 would equal $6,471.   If you end up in a higher bracket of course it would be even more.

Comparing the total payments and NPV of the different options I get :

total NPV
10 year $69,000 $55,965
25 year $104,100 $65,050
IBR $105,711 $58,409

So the IBR doesn't really come out ahead financially compared to the normal 10 year repayment plan given my example.

Now this isn't to say that IBR is a 'bad deal' or that you shouldn't sign up for it.   On the contrary if you're only making $30,000 a year and facing $575 payments I'd certainly go for the $160 payment for IBR instead.  

My point is more to say that IBR isn't necessarily a 'free lunch'.  


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