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Repayment options grow for student loan borrowers

By Lisa Bertagnoli
Published: February 11, 2013

If you're a college grad who used federal student loans to pay for college, you may be eligible for a new income-driven repayment tool: the Department of Education's Pay As You Earn Repayment Plan.

The plan, which launched Dec. 21, 2012, caps payments at 10 percent of a borrower's discretionary income. The Department of Education estimates that 1.6 million borrowers could reduce their monthly payments if they qualify.

Pay As You Earn helps some student loan borrowers

Pay As You Earn joins the older Income-Based Repayment Plan -- which caps monthly payments at 15 percent of your discretionary income -- as a way for borrowers with "partial financial hardship" to repay student loans. That means your monthly loan payments under the 10-year Standard Repayment Plan must be more than 10 percent of your discretionary income.

The government determines discretionary income based on adjusted gross income and family size. If you qualify for one of the income-driven loans, you must submit income tax returns or other proof of income each year. As long as you continue to have a partial financial hardship, you can stay in the program. As your income rises or falls, your monthly payments will grow or shrink accordingly.

The bonus with Pay As You Earn is that any balance left after 20 years will be forgiven. That's five years fewer than the 25-year limit under the Income-Based Repayment Plan, which means five fewer years of interest charges. But you will end up paying more interest under either plan than you would with the 10-year Standard Repayment Plan. (See chart.)

Who qualifies
About 2.6 percent of borrowers are already enrolled in an income-driven repayment plan, says Mark Kantrowitz, publisher of FinAid.org, a for-profit financial aid help website. Pay As You Earn could expand that enrolment to 10 percent of all borrowers.

Kantrowitz offers a quick rule of thumb: "If your debt exceeds your annual income, you should be eligible for either of the two plans," he says. To find out for sure, check out an income-based repayment calculator, such as the one on the Federal Student Aid website.

One of the key differences in eligibility for the new plan is that it's only available to borrowers who have had at least one loan disbursed after October 2011, and none before October 2007. The program will mostly benefit people who started their studies in the 2008-2009 school year or later.

Even for grads in that group, though, not every loan type qualifies for Pay As You Earn. Only federal loans made to the student -- not the parent -- will be considered. There's a lesson, says Kantrowitz: "Always borrow federal first."

You must be a responsible borrower too. With both the Income-Based and Pay As You Earn plans, borrowers cannot be in default of a loan (defined as 360 days of nonpayment). If you do default, you have one year to rehabilitate your record by making nine out of 10 payments on time. Kantrowitz warns that you have only one shot at rehab, so you have to get it right the first time. (Story continues below chart.)

  Pay As You Earn Income-Based Repayment Standard Repayment
Eligible loans Direct Subsidized and Unsubsidized Loans; Direct PLUS Loans made to graduate or professional students; Direct Consolidation Loans that don't contain PLUS loans made to parents
Direct Subsidized and Unsubsidized Loans; Direct PLUS Loans made to graduate or professional students; Direct Consolidation Loans free of PLUS loans made to parents; Subsidized and Unsubsidized Federal Stafford Loans; FFEL Plus Loans made to graduate or professional students; FFEL and Consolidation Loans without underlying PLUS loans made to parents
Direct Subsidized, Unsubsidized and PLUS Loans; Direct Consolidation loans, Subsidized and Unsubsidized Federal Stafford Loans; FFEL Plus and Consolidation Loans
Time restrictions At least one loan disbursed on or after Oct. 1, 2011; none before Oct. 1, 2007
Monthly payment cap 10 percent of discretionary income
15 percent of discretionary income
Fixed monthly payment; minimum $50
Repayment span 20 years
25 years
10 years
Monthly payment for a $30,000 debt, based on 6.8% interest $194 for a single person making $40,000 a year
$291 for a single person making $40,000 a year

Autopay is optional -- for now
To further sweeten both deals, the government reduces the loan interest rate by one-quarter of a percent for payments made via auto debit. "It's not required, but it's a good idea," Kantrowitz says.

So good, in fact, that U.S. Rep. Tom Petri is looking to make it a law. The Wisconsin Republican's Earnings Contingent Education Loans Act, introduced to the House of Representatives in December 2012, proposes a system in which employers withhold student loan payments from a borrower's paycheck, just as they do with federal and state income taxes. Deductions could not exceed 15 percent of wages.

The legislation would tie the loan interest rate to Treasury market rates, and cap total interest payments at half of the loan balance on graduation. For instance, a student who borrowed $30,000 would pay no more than $15,000 in interest.

But to pay for the interest rate cap, the legislation proposes eliminating some student-loan subsidies that help low-income borrowers -- a provision likely to rile Democrats. The bill died when the 112th Congress adjourned in January 2013; Petri's press office says he plans to reintroduce it.

The bill's aim is not just to make things easier for some borrowers. Petri argues it would boost loan repayments and cut the default rate. An FAQ document from his office indicates that in the United Kingdom, which has a similar plan, 98 percent of student-loan borrowers repay their debt. In contrast, in the United States, 13.4 percent of borrowers default on their loans within three years of graduating.

Default is a huge issue with student loans, and it is difficult if not impossible to get a federal loan discharged via bankruptcy. To do so, borrowers must prove that they cannot maintain a "minimal standard of living" if they continue to pay off the loan, according to the Student Loan Borrower Assistance Project, an arm of the National Consumer Law Center. "It's extremely difficult to get student loan forgiven," says Deanne Loonin, a Boston-based attorney and director of the organization.

The Fairness for Struggling Students Act of 2013 would extend bankruptcy rights for private student loans. That would be good news, except that private loans account for only an estimated 7 percent of student debt. And the bill is expected to face considerable opposition.

"There is momentum building, even in the lending industry, to come out in favor of some bankruptcy rights, but there's nothing concrete yet," Loonin says.

See related: Steps to make good on a defaulted student loan, 4 steps to settling privately funded student loans, Debunking a myth about wage garnishment and student loans