Student Loan Debt: New Income-Based Repayment Provides a Safety Net

With the fiscal cliff looming, at least one financial compromise has been reached and settled: President Obama’s Pay as You Earn plan for federal student loans, proposed in October 2011, was approved on November 1. For people whose loan bills are too high for their income, the new repayment plan could be a lifesaver. 

Pay As You Earn, or Income-Based Repayment, allows borrowers to pay 10% of their discretionary income (that’s the difference between your salary and the poverty line for your family size). The monthly payments are adjusted each year, as needed, based on changes in income and/or family size. This is a big difference from the standard 10-year repayment plan, which spreads the total loan amount over 10 years, with no control for whether or not that translates into a manageable monthly bill. The original plan called for payments of 15% of discretionary income, but the final version, approved by the Department of Education, is an even more manageable 10%.

The benefit, of course, of paying loans quickly, even if that means larger-than-ideal monthly payments, is that the faster they’re paid off, the less interest builds up. But even with the ever-increasing rates, interest buildup isn’t a deterrent to enrolling in the Income-Based Repayment plan. As long as payments are consistently made on time, any remaining balance after 20 years is forgiven. The original plan promised forgiveness after 25 years, but again, the final version is even more generous.

This forgiveness after 20 years, in effect, adjusts the cost of education to the salary payoff; it’s a way to protect people from education investments that end up outweighing the returns. And it’s a way to ensure that everyone can strive for the best education possible, without spending the rest of their lives keeping what they’ve learned on the back burner while they run endlessly in the rat race.

And before anyone gets up in arms about moral hazard and not borrowing more than you can repay, I think 20 years is a plenty long time to dutifully pay off student loans. Remember that the balance is only forgiven if payments are made on time every month, so it’s definitely not a handout. It’s a safety net for people who took a chance by investing in their futures and ended up unable to earn as much as they planned or hoped.

One provision of the plan is that once someone is enrolled in the plan, they can stay in it, even if their income increases dramatically. Their monthly payments would be adjusted yearly to reflect the increases, but with particularly large amounts of debt, the payments would likely still be lower than with the standard 10-year repayment plan. This is good for people who started out making particularly low payments under the Income-Based Repayment plan because it protects them from having to deal with exorbitant interest later on if they stay in the plan for the full 20 years required for forgiveness. But critics have raised some red flags about the potential for people who start out in low-paying jobs but end up in extremely high-paying ones, specifically business students who start out doing grunt work but could potentially become CEOs and walk away after 20 years with a windfall that they could easily have afforded to pay. Since the plan is brand new, it’s yet to be seen whether these pessimistic predictions will come true.

But it’s worth noting that if we eliminated every provision that exists to help low-income people because of the possibility that someone could find a way to manipulate the system to their unfair advantage, there would be no assistance programs at all, and the tax code would be unrecognizable.