In this edition of the student loan plan, we take a look at Sam’s student loan situation.
He and his wife have been on IBR for the past six years. They are looking into changing their tax strategy and repayment plan.
Sam’s Letter About Switching from IBR to REPAYE
I really appreciate the guidance here. I have been thinking a lot about my student loans lately and want to go forward with the best decision for my family.
I have been on an IBR plan since 2011. From what I am reading it is 25 years and 15% of paying until forgiveness and not 20 years. So looking to see if a different one to try and get to 20 years of paying is able to happen without hurting me in the long run Here’s some bullet points of my situation…
– my loans started at $58,000 and are now up to $69,000
– never missed a payment in 6 years of paying
– I am married and we file “married but separate” for the loan reasons
– wife also has loans from grad school ($30,000) and is also on her own IBR plan
– we have a 1 year old child
– I am 32 years old; wife is 31
– Both work full time. I’m in industrial sales and she is in HR
I know others programs are 10% of discretionary income for 20 years versus the 15% and 25 that we are each on now. Is there a penalty for switching? Or if we did would we be hit with something in the back end for doing so.
I know if they look at both of our incomes, our monthly bill would go up significantly for each of us so that’s a benefit for the IBR right now (although it hurts us during tax season by not filing jointly). But I think other programs may allow that too. I would love to just be able to wipe these out completely, but with daycare, owning a home (looking to try and move soon), and everything else in life, it’s just not feasible.
Any tips if I should stay on IBR or try to look into anything else? It’s really bugging me ha.
Revisiting the strategy
Before we get into Sam’s specific questions, we should first clear up a common misconception. Many people assume that because their spouse’s income is used to determine income-driven payments, that filing separately is usually the way to go. In the case of couples who both have federal loans, like Sam and his wife, the advantage of filing separately is often limited.
Some couples fear that by filing jointly, they will essentially be paying 30% of their discretionary income towards student loans (15% plus 15% in the case of IBR). In reality, if they file jointly, 15% of the couple’s combined discretionary income will go towards federal student loans (assuming they stick with IBR).
What people fear is that if they file jointly, by essentially combining their income, their monthly payments double. This is not the case, because Sam and his wife both have student loans. However, there may still be an advantage to filing separately, especially for couples with children.
In Sam’s case, the decision is simplified. If they switch to REPAYE, there is not benefit to filing separately. To exclude spousal income from payment calculations, borrowers need to sign up for PAYE or IBR.
Doing the exact math for couples in this situation is very easy using the Department of Education’s Loan Simulator. Borrowers can enter both incomes and student loan balances and see how different tax strategies impact their monthly payments.
Changing Repayment Plans
Sam seems to be considering a switch from the IBR plan to REPAYE (Revised Pay As You Earn). We have previously discussed the pros and cons of the various Income-Driven Repayment Plans.
The immediate perk would be lowering the monthly bill from 15% of his discretionary income to 10%.
Sam is concerned about changing is potentially running into a penalty for switching or extra cost on the back end. His gut instinct is correct as there is a cost to the switch, but it could be very minimal compared to the benefit.
For borrowers who have loan balances that are increasing each month, meaning the monthly interest on the loan is greater than the monthly payment, switching repayment plans can cause this extra interest to capitalize. When the balance is growing, that extra interest is not added to the principal balance. This is good for borrowers because it means they will not have to pay interest on the interest. However, when the interest is capitalized, the extra interest gets added to the principal balance and a borrower starts paying interest on the extra interest. Sometimes interest capitalization can be avoided; other times borrowers don’t have a choice.
The cost of switching repayment plans is interest capitalization. However, only borrowers like Sam, who have increasing balances, need to worry about this issue.
Most borrowers can switch without any cost concerns.
What should Sam do?
Any borrower looking at different repayment plan options would be wise to sit down with their tax preparer and the Loan Simulator.
We suggest Sam start by thinking about signing up for Revised Pay As You Earn and filing taxes jointly. Because we don’t have all the numbers we certainly can’t guarantee that it is the most efficient route, but it is definitely an option worth considering.
Ultimately, the only way to know for sure is to run the numbers.