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New Paper Highlights Perverse Benefits of New Income-Based Repayment Formula

Published:  October 16, 2012

In today’s tough economy, many recent college graduates are looking for ways to shrink their federal student loan payments. Income-Based Repayment (IBR), which allows students to pay a monthly amount based on their earnings, not their federal student loan balances, provides significant relief. However, a new report, Safety Net or Windfall? Examining Changes to Income-Based Repayment for Federal Student Loans, from the Federal Education Budget Project (our sister blog Ed Money Watch's parent initiative) shows that pending changes to IBR are far more generous than previously thought. Borrowers with high student loan balances and high incomes, not low-income borrowers, stand to benefit the most.

Congress created IBR in 2007 to make it easier for college graduates to make their student loan payments even in their first years out of school when they are earning lower incomes. If a student’s monthly payment under standard repayment exceeds 15 percent of his monthly discretionary income, he is eligible for the program. The borrower’s monthly payments increase as his salary increases until they reach a cap at the level he would have paid under standard repayment. After that borrower makes 25 years of payments in IBR, the Department of Education forgives any remaining loan balance.

But in 2010, at President Obama’s request, Congress made the program even more generous. The new IBR will base monthly payments on 10 percent of discretionary income, instead of 15, and loan forgiveness will be provided after only 20 years. That change was set to take effect in 2014 until the Department of Education, as part of the president’s “We Can’t Wait” initiative to circumvent legislative gridlock, sped up the availability of the new IBR by creating a version of it through regulations – “Pay As You Earn” (PAYE). PAYE will take effect by the end of the year.

But little is known about the real effects of this new IBR system. To fill in this knowledge gap, FEBP Director Jason Delisle and Program Associate Alex Holt designed and built a calculator that estimates the monthly payments a borrower will make under the original IBR, the pending version of IBR, and other repayment plans like standard 10-year and consolidation. It accounts for a borrower’s loan balance, interest rate, income, and family size over the entire repayment period. It also calculates the total payments over the life of the loan, and the amount of loan forgiveness he will receive.

The calculator revealed some surprising results. PAYE (the plan that is virtually identical to the 2014 10 percent, 20-year IBR) doesn’t necessarily target the greatest benefits to struggling borrowers. Because low-income borrowers have so little discretionary income above the poverty exemption applied annually, the new IBR only lowers their monthly payments by as little as $5 and at most $20 compared to the original IBR.

Instead, borrowers with high federal student loan balances at graduation – think law students or graduate students, since undergraduates face annual and aggregate limits on the amount they can borrow – reap the most benefit. When their incomes are low, they are able to pay manageable amounts. But as their incomes rise, their monthly payments are capped at the standard repayment amount, meaning they actually derive more benefit from IBR as they become wealthier. Plus, these borrowers often qualify for loan forgiveness after only 20 years; according to the calculator, borrowers above certain debt levels may not even pay down the interest they owe over 20 years, let alone the principal. This is a much greater benefit than is offered through the consolidation repayment plan, in which borrowers with debt totaling more than $40,000 repay their loans in full over 25 or even 30 years. And since IBR allows graduate school borrowers to take out such high loan balances with few concerns, schools have no reason to lower tuition – in fact, they have an enticement to raise it.

The report’s authors offer recommendations for changes to the PAYE/new IBR plans based on these findings. The IBR changes haven’t taken effect yet, which means there’s still time to restructure the program so it targets benefits to those who need them most. In an era of limited resources, we can’t afford to provide payouts to the rich while leaving struggling students languishing in debt.

To read the paper, click here. To try your hand at the IBR calculator, click here.


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