Revisited: Seek Forgiveness or Pay off Your Student Loans Early?

*The information contained in this post is not meant to be specific for you or your situation and is not meant to be financial advice, as I am not licensed as a financial planner. Before making any decisions, I strongly recommend speaking to someone licensed in this area to consider your unique situation. My recommendation in this area would be Will Butler.

Disclaimer: From discussions that I have had on this subject in the past, I realize that this is a controversial topic. I have never been one to shy away from discussion on touchy subjects whether ethical or financial in nature. This post will be about the financial side of the decision that I have made.

One of the first posts I ever wrote on this blog was regarding student loan repayment. This was about 10 months ago and it has been the second most popular post that I have written to date. This is not surprising considering the huge amount of outstanding student loan debt faced by many from rising tuition costs. If you have no idea about income based repayment options then it would probably be a good idea to go back and read my original post before you continue for some context. Since I wrote that post, I have continued to ponder the different options and research what is best for me financially in the long run. In the original post I concluded that the Pay As You Earn (PAYE) option was the best option in my situation and likely to be a very good option for others. Since then, I have discovered that there is an even better option available that I had completely dismissed previously.

The income driven repayment plan that I have determined is best for me financially at this point is the Revised Pay As You Earn (REPAYE) plan. This option was first introduced at the end of 2015 and at first glance it didn’t seem very enticing for those with graduate school debt, but upon further investigation, it is likely a very good option for most of us choosing between income driven repayment plans. Under the REPAYE option, your payment is set at 10% of your discretionary income which is the same as PAYE. Forgiveness for undergraduate loans occurs after 20 years, exactly like PAYE, but for graduate school loans, the remaining balance is not forgiven until 25 years of payments. The 25 year forgiveness is the reason that I didn’t initially consider this option fully since all of my loans are graduate loans. However, REPAYE has a very powerful benefit: half of all accumulated interest will be forgiven each month.

This is a huge benefit for those of us with income based payments that are less than our accumulating interest. Under the PAYE plan your balance would grow much more quickly in this situation due to the remaining interest being capitalized (added to the principle balance) at the end of each month. Let’s look at some easy example numbers to demonstrate this. If you have $100,000 in loan balance and your average interest rate is 10% and your monthly payment is $0/month based on your income, you would be accumulating $833.33 per month in interest that would be added directly onto your principle balance based on the PAYE plan. With REPAYE, this accumulated interest is cut in half and only $416.67/month would be added to your balance. The benefit will change based on your loan terms and your monthly payment, but for some this will be a blessing.

In this post I’m going to compare three different options for repayment, those being: Standard 10 year repayment, PAYE, and REPAYE. I’ll use the numbers for my personal situation and then also the numbers for a more average new grad who is taking a regular full time job. The reason my situation is different than many others is due to the tax free stipends involved in travel physical therapy. Because of these stipends, my adjusted gross income (how income based payments are determined) is not as high as it would be if I was working a full time permanent job.

Before I get to the numbers, I want to bring up some of the points from my last post that still apply.

• There is a tax deduction based on the amount of interest you pay on your student loans up to $2,500 per year, even if you don’t itemize your return. This deduction is phased out if your AGI is above $80,000, but I don’t think that will ever happen for me based on 401k contributions reducing my AGI. You do not receive that full $2,500 back on your taxes, but will receive some percentage of it based on your income, likely somewhere in the neighborhood of 20%-25%. That means somewhere around $600 being returned to you each year on your taxes. $600 x 20 years = $12,000. If you choose the standard 10 year repayment, you total deduction will be less than half of that, due to paying less interest the last few years as your principle balance decreases.
• There has been legislation proposed to no longer have the forgiven loan balance count as unearned income (meaning that you have to pay taxes on what’s forgiven), which would make loan forgiveness a much better option. There is no way to know if this will ever go through, but I would imagine there is at least a small chance over the next 20 years.
• Investing the difference between what you would have spent on the standard 10 year repayment plan and your payment on an income based repayment plan can serve as a life insurance policy of sorts. The reason for this is that student loan debt is discharged upon death. Imagine that you put all of your money toward your loans and then pass away at the end of the 10 year repayment period. You wouldn’t have any assets to leave to your loved ones. On the other hand, imagine that you choose an income driven repayment option and invest your extra money and then pass away after 10 years. The remainder of the loans will be forgiven and all of your investments can be passed on to your heirs. This may not be a game changer for many but it is something to consider.

Alright, so all of the considerations above should make one lean in favor of an income based repayment plan, but let’s look at the numbers, first for someone in a situation like mine with a lower adjusted gross income ($50,000) and a starting loan balance of $97,000 at 6% interest:

Under both PAYE and REPAYE, monthly payments would be $218 (10% of discretionary income). For standard 10 year repayment, the payment would be $1077/month.

REPAYE: ~$112,000 paid total over a 25 year period. This includes $65,400 paid in monthly payments $218 * 12 * 25 = $65,400. At the end of the 25 year period a balance of $155,400 would be forgiven. Assuming a 30% tax rate on this forgiven amount, $155,400 *.3 = $46,620. This leads to the total amount paid, $65,400 + $46,620 = $112,020.

PAYE: ~$116,800 paid total over a 20 year period. This includes $52,320 paid in monthly payments $218 * 12 * 20 = $52,320. At the end of the 20 year period a balance of $214,900 would be forgiven. Assuming a 30% tax rate on this forgiven amount, $214,900 * .3 = $64,470. This leads to the total amount paid, $52,320 + $64,470 = $116,790

Standard 10 year repayment: ~$129,000 paid total over a 10 year period. $1,077 * 12 * 10 = $129,240.

In this scenario REPAYE is clearly the winner with PAYE in second and standard repayment in last place.

Now let’s look at a scenario with the same interest rate and loan balance but with an AGI of $70,000:

Under both PAYE and REPAYE, monthly payments would be $435 (10% of discretionary income). For standard 10 year repayment, the payment would be $1077/month.

REPAYE: ~$162,900 paid total over a 25 year period. This includes $130,500 paid in monthly payments $435 * 12 * 25 = $130,500. At the end of the 25 year period a balance of $107,900 would be forgiven. Assuming a 30% tax rate on this forgiven amount, $107,900 *.3 = $32,370. This leads to the total amount paid, $130,500 + $32,370 = $162,870.

PAYE: ~$140,100 paid total over a 20 year period. This includes $104,400 paid in monthly payments $435 * 12 * 20 = $104,400. At the end of the 20 year period a balance of $119,100 would be forgiven. Assuming a 30% tax rate on this forgiven amount, $119,100 * .3 = $35,730. This leads to the total amount paid, $104,400 + $35,730 = $140,130

Standard 10 year repayment: ~$129,000 paid total over a 10 year period. $1,077 * 12 * 10 = $129,240.

Uh oh, in this scenario we can see the impact that the extra five years of repayment has when the accumulating interest is less each month due to a higher monthly payment. This puts REPAYE in last, PAYE second, and standard 10 year repayment first. But not so fast, there is a very important factor that is not being accounted for here.

Monthly payments under any income based repayment plan are based on your adjusted gross income. Your adjusted gross income is reduced with eligible deductions such as 401k contributions ($18,000 maximum per year), traditional IRA contributions ($5,500 maximum per year) and HSA contributions ($3,350 maximum per year). This means that making smart decisions for your retirement will not only help you later in life but also will decrease your AGI and therefore your total amount paid on your loans when using an income driven repayment plan.

So if $70,000/year AGI leads to paying more overall when using an income driven repayment plan and $50,000/year AGI leads to a lower overall amount paid, you may be wondering where the cut off values are for this scenario. Well, I spent a long time trying to figure out how to display this in a graph (I’m not great with Excel) and here is what I came up with:

The Y axis is the total amount paid over the life of the loan. The X axis is yearly AGI. Keep in mind that these numbers are based on $97,000 in direct subsidized loans with an average interest rate of 6%.

Based on the graph for this scenario, if your AGI is below ~$52,500 you come out ahead with REPAYE. If it’s between ~$52,500 and ~$58,000 then PAYE is the best choice and if your AGI is above $58,000 then the standard 10 year repayment is the best option. That seems simple enough, but the total amount paid doesn’t tell the whole story. The reason for this is that with PAYE that amount is paid over 25 years, with PAYE it’s paid over 20 years and with the standard repayment it is paid over 10 years. In that 15 year period between the standard repayment finish date and the REPAYE finish date, the value of money will generally decrease by quite a bit. Historically, the dollar loses 35% of it’s spending power in an average 15 year period due to inflation. Trying to factor inflation into each payment over the 25 year period is way above my level of Excel prowess, but it would likely push these cut off numbers to the right by a decent amount making the argument for income driven repayment even better.

Now I’ve talked to a lot of other new grad physical therapists over the years and it seems that, unfortunately, $100,000 in student loans is on the low end of the spectrum. For that reason I made a graph for those with $150,000 in student loans at an average interest rate of 6% to see what the difference would be:

On this graph we can see where income driven repayment plans really shine. As total student loan debt increases, the argument for income based plan repayment plans becomes much better. If you have $150,000 in student loan debt at an average interest rate of 6%, you would have to have an AGI of well over $80,000 (factoring in inflation) in order to come out ahead by using the standard repayment option. Although the numbers are interesting to see, it shouldn’t come as a surprise that having high student loan debt makes income driven repayment a better option because these are the exact people for which these plans were made.

Alright so let’s try to wrap this all up and come to some sort of a conclusion.

From the very beginning of your career, you should be contributing a decent amount (likely 10-15% or more) of your income to tax advantaged accounts (401k, traditional IRA, HSA). This will not only allow you much more freedom later in life but also reduce your student loan payment and total amount paid under an income driven repayment plan. Putting $10,000 per year into a combination of a 401k and HSA can lead to a significant reduction in your AGI, which not only spares you in taxes at the end of the year but also reduces the total amount paid over the life of your loans ($20,000+ in some of the scenarios above). The higher your student loan balance, the more likely that an income driven repayment plan is the best option for you. The lower your AGI, the more likely an income driven repayment plan is the best option for you. Inflation has a significant impact on money over time, so paying $100,000 over a 25 year period is far from the same as paying $100,000 over a 10 year period. Tax deductions for payments made on student loan interest can lead to significant savings over a 20-25 year period which makes income driven repayment plans even more compelling. The tax rate I used for the forgiven balances in the examples above was 30%, but this will be different based on your situation. Personal preference should be a factor in your decision. I have talked to some people that are extremely debt adverse and although they may come out ahead with an income based option, it isn’t worth the psychological stress carrying the debt would cause for them over such a long time.

One last thing to note is that I did not account for any sort of yearly increase in pay in the calculations above. There are three reasons for this: first, because it is impossible to generalize a standard increase in pay because everyone’s career will be different. Second, because I have spoken to very few physical therapists that have worked 25 straight years full time. Most seem to transition to PRN or part time as they advance in their careers which will obviously mean a lower AGI later on, not higher. Third, because as your pay increases throughout your career, you should strive to keep expenses close to the same level and contribute the difference to tax advantaged investment accounts which would keep your AGI, and therefore your payments, at the same level.

I know this is a lengthy post, but this is not a simple topic. I get a lot of questions regarding student loans and I want this to be a resource for new grads that are lost. What is your opinion of standard repayment vs. income based repayment? I’d love to hear your thoughts in the comments.