Attention Student Loan Borrowers: Can You Pass my Repayment Test?

I fear many student loan borrowers are flunking out when it comes to choosing the right repayment plan.  Here’s a quick quiz to test your repayment smarts:

You have about $29,000 in federal student loans. That’s the average for borrowers who attended a private four-year non-profit school. You’re single and your adjusted gross income is $25,000.

What’s the best repayment plan?

A. The standard 10-year plan that will require monthly payments of nearly $300 a month. After 10 years the loan is completely paid off. You are done!

B. An income-based plan that can set your initial monthly payment below $20 and after 25 years of payments your remaining balance is forgiven-you are no longer on the hook for any remaining balance.

I bet you think B is the way to go.

Not so fast.

As enticing as it is to start with a low monthly payment, income-contingent repayment plans that forgive any remaining balance after a set period can end up costing you plenty.

For starters, interest payments over 25 years are going to cost you more than interest payments over a 10-year loan term. Using the same loan assumption from above, total interest payments over 10 years would be around $6,100. Under the Income-Based Repayment plan (IBR) interest payments would be more than $26,000 over the 25 years until the loan is forgiven. Add the principal payback and your total all-in repayment cost under the Standard 10-year plan is around $35,000. Even though the IBR starts you with a lower monthly payment the cumulative effect of payments and interest payments over 25 years ends up costing you more than $43,000.

But wait, it gets worse. Under current law, any remaining balance that is forgiven after 25 years will be treated as taxable income in the year it is forgiven. Yep, you will get a 1099-C tax form that notifies you that the unpaid balance was reported to the IRS, which in turn is going to expect you to pay income tax. Using the same example once again, the forgiven balance is more than $12,000. Even if your salary that year is low, adding $12,000 to your income could likely push you into a higher tax bracket.

We don’t know what tax rates will be 25 years down the line, but even if I am generous and assume you’d somehow still be in a super low 10% bracket, that’s an extra $1,200 to settle with the IRS, bringing your total loan costs to nearly $45,000. Or about $10,000 more than what you’d owe under the 10-year repayment plan. (Recent borrowers with loans taken out after June 30, 2014 there’s a new repayment plan called Pay as You Earn (PAYE). Like IBR, if you qualify your initial payments are low. After 20 years or repayment the remaining balance is forgiven. But the same tax hit applies.)

I hope that opens your eyes to the true cost of opting for a long repayment schedule. I highly encourage you to play around with the government’s Student Loan Repayment Estimator. You can get customized estimates based on your actual outstanding loans, and the costs under different repayment plans based on your income, family size and where you live. (Eligibility for income-based plans is based on state-level income cutoffs. For the above example I assumed a single resident of Illinois with $25,000 in adjusted gross income.)

I totally understand how hard it may be to consider the higher payments that come with a 10-year repayment plan. But I want you to think long and hard if you can pull this off. Not only will you save a lot of money in the long run, you will have this debt completely paid off in 10 years. That’s a nice load off your finances and your conscience. Or you might consider working in a public service job that makes you eligible for the Public Service Loan Forgiveness Program. After 10 years of on-time payments your loan will be forgiven, and the IRS does not require you to pay tax on the forgiven balance.