Avoiding IBR Bombshells

I’ve said before that financial planning is often simple, but not easy. In the case of student loan planning, it can be complicated and not easy.

For those of you who have determined that Income Based Repayment (IBR) may not be the best plan for your situation, you may be tempted to switch plans.

As you navigate this potential change, consider the following items.

Switching plans causes accrued interest to capitalize.

One of the triggers for interest capitalization occurs when you leave the Income Based Repayment plan. Capitalization is the process of accrued interest being rolled into your student loan principal balance.

So what’s the big deal?

Capitalization causes your original loan balance to grow. This larger balance generates more interest moving forward. If you’re going for Public Service Loan Forgiveness (PSLF) and you expect the entire amount to be forgiven anyway, capitalization may not be as much of a concern to you—unless you decide not to go for PSLF in the future, or worry about the viability of the program.

Interest capitalization may be especially concerning for those NOT going for PSLF but are considering whether or not to leave the Income Based Repayment program. Because those not going for PSLF will be responsible for footing their entire student loan balance, a larger principal whereon interest grows may not be a good move, no matter the benefits of other repayment plans. Individual circumstances will dictate whether or not this is the case for you.

Additionally, unlike Pay As You Earn (PAYE) where the amount of interest capitalized is limited to 10% of your principal loan balance at the time you entered PAYE, IBR has no limit on the amount of interest that may be capitalized. (See here).

Getting placed on the Standard Repayment Plan.

An interesting phenomenon happens when you decide to switch from the Income Based Repayment plan to a different plan. Here’s what I uncovered in the final question in the  miscellaneous Q&A section of the studentaid.ed.gov website (Emphasis mine):

Generally, if you’re repaying your loans under an income-driven repayment plan, but decide for any reason that you want to change to a different repayment plan (either to another income-driven repayment plan or to a traditional repayment plan), you may change to any other repayment plan for which you are eligible. The only exception is that if you want to change from the IBR Plan to a different repayment plan, you’ll initially be placed on the Standard Repayment Plan. If you then want to change from the Standard Repayment Plan to a different repayment plan, you must first make at least one payment under the Standard Repayment Plan or one payment under a reduced-payment forbearance.

So with any other income-driven repayment plan, you may change to a different repayment plan for any reason, so long as you are eligible for that plan. HOWEVER, if you decide to change from IBR, you will first be placed on the Standard Repayment Plan. Then you may change to a different plan after first making a payment under the Standard Repayment Plan.

The Standard Repayment plan is set up to pay off your student loans after 10 years of repayment. Logically, these payments are larger than what you likely pay under income-driven repayment.

Let’s use an example for illustrative purposes.

Using the studentaid.ed.gov repayment estimator let’s assume that you’re a single individual living in Illinois with a federal student loan balance of $200,000.00 at 6% interest. You have no dependents and your adjusted gross income (AGI) is $55,000. Under the old IBR program your monthly payment would be $453. Under the new IBR program, PAYE, and REPAYE, your payments would be $302. However, the Standard Repayment Plan monthly payment would be $1,199!

Quite the bombshell.

Using the same assumptions, but only changing our individual to a married couple filing a joint tax return with two dependent children, the Standard Repayment plan is still $1,199 per month. PAYE, REPAYE, and the new IBR are $136 per month, and the old IBR is $205.

For the resident going for PSLF, a month under the Standard Repayment Plan goes against the strategy of keeping payments as low as possible in order to maximize forgiveness. For all residents (whether or not they are going for PSLF), a monthly payment on the Standard Repayment Plan may be especially painful from a cash flow perspective.

Reduced-payment forbearance to the rescue.

Even if you wanted to leave Income Based Repayment, after learning that you have to make a one-month payment under the Standard Repayment Plan, you might decide that it’s not worth it, or possible, considering your cash flow situation. But hold on a minute.

Let’s revisit that quote from the miscellaneous Q&A section of studentaid.ed.gov (Emphasis mine):

Generally, if you’re repaying your loans under an income-driven repayment plan, but decide for any reason that you want to change to a different repayment plan (either to another income-driven repayment plan or to a traditional repayment plan), you may change to any other repayment plan for which you are eligible. The only exception is that if you want to change from the IBR Plan to a different repayment plan, you’ll initially be placed on the Standard Repayment Plan. If you then want to change from the Standard Repayment Plan to a different repayment plan, you must first make at least one payment under the Standard Repayment Plan or one payment under a reduced-payment forbearance.

What is a reduced-payment forbearance? That’s a great question. There isn’t any additional information readily available from traditional pages of the studentaid.ed.gov website. However, using the Demo Income-Driven Repayment (IDR) Plan Request I was able to uncover the following details under the “Certify and Sign” section:

  • If I am currently repaying my Direct Loans under the IBR plan and I am requesting a change to a different income-driven plan, I request a one-month reduced-payment forbearance in the amount of my current monthly IBR payment of $5, whichever is greater (unless I request another amount below or I decline the forbearance), to help me move from IBR to the new income-driven plan I requested.

In other words, it would appear from this section that reduced-payment forbearance is the default when switching out of IBR. I want to make clear here that I’m actually not sure. I would have expected the default to be the Standard Repayment Plan payment for one month and not the reduced-payment forbearance. I also believe this statement contains a typo that makes it a bit confusing.

Here’s what I mean: This section originally says (Emphasis mine), “I request a one-month reduced-payment forbearance in the amount of my current monthly IBR payment of $5, whichever is greater . . .” From the context, it would seem to me that this should actually read (change and emphasis mine) “. . . in the amount of my current monthly IBR payment or $5, whichever is greater . . .”

If anyone has actually made the IBR switch, I would love to hear your thoughts on how this actually works in practice, and whether or not my “correction” above is accurate.

  • If I requested a reduced-payment forbearance of less than $5 above, my loan holder will grant my forbearance request in the amount of $5.

Sounds like $5 is the minimum reduced-payment forbearance that you can make. Quite a difference from the Standard Repayment Plan payment amount.

  • If I am requesting a change from the IBR Plan to a different income-driven repayment plan, I may decline the one-month reduced payment forbearance described by contacting my loan holder. If I decline the forbearance, I will be place on the Standard Repayment Plan and must make one monthly payment under that plan before I can be placed on a different repayment plan.

Apparently you could decline the one-month reduced monthly forbearance. This seems to further indicate to me that the default is one month of reduced-payment forbearance, rather than having to make a payment under the Standard Repayment Plan. Again, if you’ve actually made this switch, please let me know how it went down.

Ben White in his book, Medical Student Loans: A Comprehensive Guide writes, “In practice, the “reduced-payment” requirement is $5. So, you don’t need to shell over a few thousand to cover a month’s standard repayment. On the other hand, a reduced-payment month won’t count towards PSLF.”

Dr. White confirms the reduced-payment forbearance at $5, and he also states that the reduced-payment forbearance won’t count towards PSLF. At this point I’m 99% certain that Dr. White is correct, but haven’t read an original source document on it. (Dr. White, if you read this, send me your original source.)

Some final thoughts.

Switching from IBR may be right for you. It may not. As you consider that option, take account of the consequences that will come from switching plans. That way you will be prepared for, and not surprised by, the results of leaving the IBR plan.

Again, if anyone has experience actually switching from IBR to another plan, I would love to hear how the process went for you in “real life.” Please shoot me an email at donovansanchez@skyviewplanning.com.


Disclaimer:

The content you just read is for informational purposes only. Yes, I’m a financial advisor, but this article really isn’t intended as advice for you specifically. Your unique situation needs to be taken into account, and the ideas presented here may not apply.

So, please make sure you do your due diligence BEFORE implementing anything. Due diligence may include hiring a qualified professional who understands your situation completely and can offer you personalized advice.


Donovan Sanchez