I'm a Resident Physician: Which Income-Driven Repayment Plan Should I Choose?
In my previous article I discussed forbearance during residency. If you’re like most residents, forbearance likely wasn’t for you. If you’re not forbearing repayment of your federal student loans, what are your options?
The next logical step will be to review and select an income-driven repayment (IDR) plan. You do this in order to make your monthly payments manageable, as well as to qualify for PSLF.
There are a number of IDR plans, but in terms of relevancy for most residents, Revised Pay As You Earn (REPAYE) and Pay As You Earn (PAYE) will be focused on in this article. That doesn’t mean that Income Based Repayment (IBR) or Income Contingent Repayment (ICR) won’t be applicable to you, however. You’ll need to carefully consider your options, and/or hire a professional to help you through the process.
Using income-driven plans to reduce monthly repayment.
Income-driven repayment plans calculate your monthly payment based on a percentage of your discretionary income. Your discretionary income is determined by your adjusted gross income (AGI), the poverty line in the state you live in, as well as your family size (including unborn children). Considering the factors used to determine discretionary income, planning opportunities to lower payments are possible by reducing your adjusted gross income, such as saving into pre-tax accounts like 401(k)s, HSAs, or IRAs, as well as making sure that you recertify when your family size changes.
In fact, if your family size is large enough, and you’re able to reduce discretionary income through pre-tax contributions, it’s possible to reduce your monthly payment as low as ZERO. For those of you interested in Public Service Loan Forgiveness (PSLF), these payments of $0 still qualify as part of your 120 payments required for tax-free forgiveness.
If you are going for PSLF, your strategy is to reduce student loan payments as much as possible in order to increase the total amount that is forgiven after 120 qualifying payments. Make sure that you recertify when your family size increases or you are able to increase pre-tax savings.
What is REPAYE?
Revised Pay As You Earn or REPAYE is the newest income-driven repayment plan available. However, not all loans are eligible. Some loans may be eligible if consolidated, while others may not. Eligible loans include Direct Subisidized Loans, Direct Unsubsidized Loans, Direct PLUS Loans made to graduate or professional students, Direct Consolidation Loans (but only those that do not repay PLUS loans made to parents), among others. PLUS loans made to parents or any Consolidations loans that repaid PLUS loans to parents are not eligible. Other loans may or may not be eligible. More information on that may be found here. Remember that consolidating loans under the Direct Consolidation program results in a new loan and restarts the repayment clock to your 120 required payments for PSLF. Be careful before you consolidate to make sure you’re not losing credit towards PSLF.
REPAYE qualifies for tax-free PSLF, as well as taxable forgiveness after 20 years for undergaduate loans and 25 years for graduate and professional loans. Payments amount to 10% of your discretionary income no matter what your income is. In other words, while REPAYE may offer a nice reduced monthly payment in residency, the payment can balloon to higher than the Standard Repayment Plan when your income increases as an attending.
One of the unique aspects of REPAYE that make it attractive to even those NOT seeking PSLF is the 50% forgiveness of unpaid interest. Technically, the government will forgive 100% of unpaid interest on subsidized loans for the first 3 years in the program, and then 50% of unpaid interest on subsidized loans in the years following. It’s the unpaid interest on unsubsidized loans that enjoy 50% forgiveness upon entering the program.
In Dr. James Dahle’s (The White Coat Investor) latest book, Financial Boot Camp, he writes
The largest advantage of the REPAYE program is that the government effectively subsidizes the interest rate during your training period. It will waive half the difference between your payments and the accruing monthly interest. So if your payment is $200 a month, and the interest is $1,000 per month, only $400 a month will be added to the total loan burden, and the government will waive the other $400. Because of this subsidy, this is the preferred program for most residents to enroll in upon entering residency. Certainly, this is the correct default plan for single residents and those married to a non-earner or a low earner. (71)
Let’s break out Dr. Dahle’s example a little more. Assume that you have $200,000 in unsubsidized student loans at a 6% interest rate. The interest generated off of the student loans is $12,000 per year or $1,000 per month. When you make your monthly payments, the payment is first applied to interest. Each month you pay $200, and $800 of unpaid interest is left remaining. Under REPAYE the government will pay $400 of this remaining interest, leaving only $400 interest left to accrue.
Because of this subsidy, those who have decided that they are not going for PSLF and are looking at refinancing during residency should still explore whether the effective interest rate under REPAYE is actually better than the interest rate being offered by student loan refinancing companies.
How to calculate the effective interest rate under REPAYE. (Skip if you don’t like math.)
Using the example above, the effective interest rate is calculated by annualizing the $200 monthly payment and adding it to the annualized amount of interest not forgiven. $200*12 + $400*12 = $7,200.
This amount is then divided by the original $12,000 interest amount. ($7,200/$12,000) = 60%.
Therefore, the effective interest rate under REPAYE is only 60% of the original 6% interest rate. As such 0.06 * 0.6 = 0.036 or 3.6%.
The effective interest rate under REPAYE in this example is 3.6%. Before you refinance with a private company, make sure that the rate you are being offered is better than the effective rate under REPAYE.
What is PAYE?
Unlike REPAYE, you actually have to qualify for the income-drive repayment plan Pay As You Earn (PAYE). To qualify, your monthly payment under PAYE must be less than the amount that you would have to pay under the Standard Repayment Plan. Technically you also need to be a “new borrower.” (See here for information on what that means.)
Eligible loans under PAYE include Direct Subsidized Loans, Direct Unsubsidized Loans, Direct PLUS Loans made to graduate or professional students, Direct Consolidation Loans (but only those that did not repay PLUS loans made to parents), among others. PLUS loans made to parents or any Consolidation loans that repaid PLUS loans to parents are not eligible. Other loans may or may not be eligible. More information on that may be found here.
Similar to REPAYE, the monthly payment under PAYE is 10% of your discretionary income. However, unlike REPAYE, the monthly payment under PAYE will never be more than the 10-year Standard Repayment Plan amount. Why is this important? We’ll review that more in the next section.
PAYE qualifies for tax-free PSLF, as well as taxable forgiveness after 20 years of repayment. Under PAYE, borrowers may also file their taxes as married filing separately (MFS). This is not available under REPAYE. The married filing separately strategy may be worth exploring if you are a resident and are married to a high income earner. Filing separately allows you to exclude your spouse’s income, so only your income will be taken into account when determining your discretionary income. However, filing separately may increase your tax burden, so your accountant will need to run the numbers to determine if the amount saved in reduced student loan payments is greater than any potential increase in taxes while filing married filing separately.
Lastly, under PAYE, interest will be capitalized (added to the loan principal) when you no longer qualify to make payments that are based on your income. In this scenario, however, the amount of interest that will capitalize will only be 10% of your total loan balance at the time you entered into PAYE. You’re still responsible for the total amount of unpaid interest, it’s just not capitalized to the loan principal. If you leave PAYE, however, there is no 10% limit on the amount of unpaid interest that may be capitalized.
The REPAYE to PAYE strategy for physicians seeking PSLF.
Physicians are unique in the financial planning landscape for a number of reasons, but one of the most important ones for student loan planning has to do with the fact that you go from making little more than a high school teacher’s salary to a quadrupling of your income overnight when you finish your training and become an attending. Under REPAYE, this creates a problem because there is no payment cap, and your monthly payment will equal 10% of your discretionary income, no matter that amount.
For this reason, residents and fellows should consider switching from REPAYE to PAYE as they near the completion of their training. Remember, in order to qualify for PAYE, an individual must meet a number of factors, including having monthly payments under PAYE that are less than the amount that would have been payable under the Standard Repayment Plan.
Under PAYE, the monthly payment will never be more than the 10-year Standard Repayment Plan amount. This can potentially save you money as you continue working towards PSLF.
Some final thoughts.
Student loan planning is, unfortunately, very complicated.
You won’t be surprised to find me saying that your unique situation will determine the path you should take. If you find yourself struggling with your student loan planning and looking for direction, I encourage you to speak with a qualified professional to help you determine your next steps forward.
These are my opinions, unless I’ve specifically cited other material. The information and ideas I’ve presented are for informational purposes only. Before you implement anything, make sure you have a thorough discussion with a qualified professional who understands your situation.