Credit Debt

Income-Based Repayment For Student Loans

Graduating from law school and business school in the aftermath of the Great Recession and a particularly weak legal employment market meant that I had as much debt as a first-time home-owner and little to no steady income. As I looked for permanent work with little success, the first of my daunting, monthly debt payments loomed large in my mind. Not only was there no way for me to realistically make the mortgage-sized debt payments each month, but throwing in the towel was not an option. Federal student debt is one of the few debts that are not discharged in bankruptcy, except in some very rare circumstances.

I was not alone in this situation. There were and are thousands of students in the same boat. One solution introduced during the Obama Administration and aftermath of the 2008 Financial Crisis was Income Based Repayment (IBR). IBR pegs a graduate's monthly loan payments to his income (try the calculator here). So if you have a six-figure debt but are only making $30K/year, your monthly payments could be under $20. Once you establish yourself in your career, your payments increase and you end up paying it all off anyway. And if you haven't paid it all off after 20 or 25 years (depending on when you opted into the program), the balance is forgiven and you owe no more student debt.

The program sounds amazing, and for many recent graduates it is the only thing fending off financial ruin; there are two important downsides, however: increasing interest and U.S. tax policy.

Let’s start with increasing interest. My student loan debt carries an interest rate of 6.8 percent, much higher than most home mortgages and car loans. While being able to pay a fraction of my otherwise unmanageable monthly payment allows me to pay rent and buy groceries, it also means the size of my loan continues to grow at close to 6.7% interest per year, depending on how much I manage to pay off via my reduced payments. After years of paying a fraction of what monthly payments would be without the relief of the IBR, a graduate’s principal can grow to a staggering size. If that graduate’s income doesn’t eventually catch up to the size of the debt, there could be no end in sight to this growth.

The IBR’s solution to this problem creates the second problem: Depending on when you opted into the IBR, your remaining debt is entirely forgiven after 20 or 25 years. It doesn’t matter if you owe $5,000 or $500,000; the debt goes away. Sort of. Under U.S. tax law, debt forgiveness is considered a form of income. The rationale is that getting rid of an obligation to pay someone money is analogous to gaining money equal to that debt. So if you still owe $100,000 at the time your debt is forgiven, the IRS sees that as no different than you earning $100,000 on top of your other income. This means you have an immediate tax liability of roughly 30-40 percent of your income, depending on your tax bracket.

For many graduates, including myself, the IBR is an essential component of post-graduate financial life. I couldn’t afford to pay my true monthly payments without it. And yet it is important to understand the drawbacks of this program and not think it is a flawless cure to your student debt.