pay the minimum on PAYE

Reader Question: Should I pay the minimum on PAYE?

Michael Lux Best Of, Blog, Mailbag, Student Loans 0 Comments

I am currently finishing residency after dentistry school and my loans are close to 170K.  I consolidated and signed up for PAYE plan.  Currently I am in administrative forbearance until hopefully I am approved.

My question is, what is the incentive of making more than the minimum payments every month if my loan will be forgiven after 20 years??  It’s impossible to calculate my future income, but let’s average it out to about 170K as a dentist. (Not starting out, but eventually).

Would it make sense to make higher monthly payments and plan on paying the loan off rather than awaiting loan forgiveness?  This is considering at 10% of income I would be paying 17K of loans per year.

This is difficult question to answer and one that is impossible to give a specific answer.  There are simply too many variables for anyone to know for certain what is the best route to go.  This is a situation that many young professionals face.  However, what I can do is tell you some of the things you should consider when you put together your plan.

Always remember the interest

One of the areas where federal loans can be a big pain is interest rates.  Where you might be able to get less than 3% on the private market, federal loan interest rates are locked in based upon when you borrowed.  You ability to pay and creditworthiness do not affect your interest rate.  As a result most borrowers are paying back federal loans at an interest rate of 6 to 9%.

This high interest rate becomes especially important when it comes to income based plans.  For people still in their residency or early on in their careers, they may end up paying less than their yearly interest.  On one hand this is good because it is progress towards forgiveness, but as your income hopefully grows, you could be looking at a much bigger balance.

Depending on your interest rate and possible future earnings, if you will likely be paying off your loan in full before you get forgiveness, it makes sense to pay as much as possible and get the loan paid off as quickly as possible to avoid interest.  However, if you are certain that you will be qualifying for forgiveness or unable to pay much above the minimum payment, it doesn’t make sense to pay anything more than the minimum.

How much do you trust the politicians in DC?

PAYE, Income Based Repayment, and Student Loan Forgiveness were all created by federal law.  It also means that a new law can change these programs.

If you are planning on having your loans forgiven in 20 years, it means you are betting on the federal government not to change the program for you.  On one hand, it would be absurd to change a program that people were relying upon, on the other hand, would it really surprise you to have a bunch of politicians go back on their word?

It is really hard to factor in this detail, but if your math has you right on the edge, and you can’t decide which way to go, it might be best to play it safe and just pay off the loans to avoid getting heartbroken by Congress and crushed with interest.

Don’t forget about the tax man!

Any accountant will tell you that debt forgiven is considered income to the IRS.  PAYE is kind of tricky because the loans forgiven are only taxable some of the time.  If your loans are forgiven after 10 years as part of the public service loan forgiveness program, you will not have to pay any taxes.  However, if you have your loans forgiven after 20 years, that forgiveness is taxable.

There is growing support to make all loan forgiveness non-taxable, but as the law currently stands, the forgiven debt after 20 years on PAYE is considered income.  That means that if you make 30k a year and have 100k forgiven, your taxable income for that year will actually be $130,000.  That would make for a huge bill!

Bottom line, make sure your student loan debt problem doesn’t become a tax problem.  Depending upon your income, you may want to save for years to be ready to pay off a huge tax debt.

How do I decide?

The key here is to make an honest objective assessment about your finances and the reality of the situation.  As time passes, this is definitely one of decisions that you may want to revisit.  Laws change, your finances change, and situations change.  Regardless of what you decide, do your best to be prepared to adjust to changes that may arise in the future.