The Pay-As-You-Earn repayment plan was enacted by the Health Care and Education Reconciliation Act of 2010, with an effective date of July 1, 2014. President Obama used his regulatory authority to make the pay-as-you-earn repayment plan available to some borrowers starting on December 21, 2012 by transforming a version of income-contingent repayment into pay-as-you-earn repayment.
Pay-As-You-Earn (PAYE) repayment is one of several repayment plans for federal student loans where the monthly loan payments are capped based on a percentage of the borrower’s discretionary income, with remaining debt forgiven after a specified number of years in repayment. The other repayment plans are Revised Pay-As-You-Earn Repayment (REPAYE), Income-Contingent Repayment (ICR), Income-Based Repayment (IBR) and Alternative Repayment. Income-Sensitive Repayment (ISR) bases the monthly payments on a percentage of the borrower’s gross monthly income, as opposed to discretionary income. These repayment plans make the debt more affordable for a borrower whose debt is out of sync with his or her income.
Pay-As-You-Earn (PAYE) Repayment Formula
PAYE = 10% (AGI - 150% x Poverty Line) / 12
The monthly payment under pay-as-you-earn repayment is based on 10 percent of discretionary income, where discretionary income is defined as the amount by which adjusted gross income (AGI) exceeds 150 percent of the poverty line. The poverty line is based on the borrower’s family size and state of residence.
(For many borrowers who qualify for pay-as-you-earn repayment, the monthly payment will be less than 7 percent of the borrower’s monthly income. Examples include borrowers with a family size of one with AGI of $50,000 or less and borrowers with a family size of four and AGI of $100,000 or less.)
If the monthly payment as calculated by the pay-as-you-earn repayment formula is less than $5, the monthly payment is set to zero. If the monthly payment is greater than or equal to $5 and less than $10, the monthly payment is set to $10. Thus if the borrower’s AGI is less than 150 percent of the poverty line, the monthly payment will be zero.
Note that if the required monthly payment is zero, it still counts as a payment. A borrower with a required payment of zero is not considered to be delinquent. A required payment of zero also counts as a payment for the purpose of loan forgiveness.
Any remaining debt is forgiven after 20 years’ worth of qualifying payments. This forgiveness includes accrued but unpaid interest in addition to the remaining principal balance of the loan. Borrowers who qualify for the 20-year forgiveness will receive an IRS Form 1099-C from the U.S. Department of Education because the cancelled debt is treated as taxable income under current law. This is in contrast with the public service loan forgiveness program, where the remaining debt is forgiven after 10 years (120 qualifying payments) instead of 20 years (240 qualifying payments). The loan forgiveness under public service loan forgiveness is tax-free under current law, since the forgiveness is excluded from income.
The easiest way of applying for pay-as-you-earn repayment is to choose the repayment plan online at StudentLoans.gov. Borrowers can also file an Income-Based (IBR) / Pay As You Earn / Income-Contingent (ICR) Repayment Plan Request form with their loan servicer. (Borrowers who don’t remember the name of their servicer can visit the National Student Loan Data System (NSLDS) or call 1-800-4-FED-AID (1-800-433-3243) to get their servicer’s contact information.)
Capitalization of Interest
It is possible for the pay-as-you-earn repayment plan to be negatively amortized, where the monthly loan payment is less than the new interest that accrues.
The federal government will pay the accrued but unpaid interest on any Direct Subsidized Loan for the first three years of repayment under the pay-as-you-earn repayment plan.
Otherwise, the unpaid interest will accumulate and can be capitalized (added to the loan balance) when the borrower is no longer eligible for pay-as-you-earn repayment or chooses to switch to a different repayment plan. However, when a borrower no longer qualifies for pay-as-you-earn repayment because the borrower no longer has a partial financial hardship, the capitalization of interest stops when the outstanding principal balance is 10 percent greater than the original principal balance when the loan entered repayment. Interest then continues to accrue, but is not capitalized. If the borrower chooses to leave pay-as-you-earn repayment, all unpaid interest is capitalized at that time.
While the unpaid interest will cause the debt to grow, any remaining interest will be forgiven along with the principal balance when the borrower has made 20 years’ worth of qualifying payments under the pay-as-you-earn repayment plan (10 years’ worth of qualifying payments for the public service loan forgiveness program).
The interest paid is deductible under the student loan interest deduction. However, if a married borrower chooses to file federal income tax returns as married filing separately to get a lower loan payment under pay-as-you-earn repayment, the borrower will not be eligible for the student loan interest deduction. Borrowers who file federal income tax returns as married filing jointly remain eligible for the student loan interest deduction.
Determining the Monthly Loan Payment
The monthly loan payment under pay-as-you-earn repayment is based on the borrower’s income and the poverty line for the borrower’s family size. It may change each year based on the borrower’s income during the past year and changes in the family size. A tutorial gives a step-by-step example of how to calculate the monthly payment under the pay-as-you-earn repayment plan.
If the borrower’s income increases enough that the borrower no longer has a partial financial hardship or if the borrower chooses to change the repayment plan, the borrower may switch back into standard 10-year repayment. The monthly payment under standard 10-year repayment will be based on what it would have been before the borrower started the pay-as-you-earn repayment plan. As a result, it may take more than ten years for the borrower to pay off the remaining debt. These payments count toward the loan forgiveness period, as the borrower is still considered to be in the pay-as-you-earn repayment plan, albeit with monthly payments based on standard repayment.
The borrower may choose to switch into extended repayment or graduated repayment, but then the loan payments will not count toward the loan forgiveness period if they are less than the monthly payment under standard repayment.
If the borrower’s income subsequently decreases, the borrower may once again qualify for pay-as-you-earn repayment.
If the borrower’s income changes mid-year, the borrower can appeal for an adjustment to the loan payment by filing an alternative documentation of income form. Borrowers will also be required to file this form during the first year in the pay-as-you-earn repayment program. Married borrowers who live in community property states and file separate federal income tax returns may use this form to have the repayment obligation based on the borrower’s income as opposed to half the borrower’s and spouse’s combined income.
The reduction in the monthly payment under pay-as-you-earn repayment as compared with standard repayment is maximized when the borrower’s AGI is less than 150 percent of the poverty line and when total education loan debt exceeds AGI (increasing with increasing debt). When AGI is less than 150 percent of the poverty line, the monthly payment is zero.
For example, if a borrower owes $30,000 in Direct Unsubsidized Loans at 6.8% interest, the monthly loan payment under standard repayment is $345. Under pay-as-you-earn repayment, the monthly payment is zero when the borrower’s AGI is $17,235 or less. If the borrower’s family size is one and the borrower’s AGI is $30,000, the monthly payment is $106, reducing the monthly payment by more than two-thirds. The borrower will cease to be eligible for pay-as-you-earn repayment when the borrower’s AGI is $58,635 or more.
This table shows the monthly payment based on 2013 poverty line figures for the continental U.S. based on the family size and adjusted gross income.
Generally, only federal student loans, such as Direct Subsidized and Unsubsidized Loans and Grad PLUS Loans, are eligible for pay-as-you-earn repayment. Federal consolidation loans that refinance Direct Subsidized and Unsubsidized Loans and Grad PLUS Loans are also eligible. The Perkins Loan is not eligible for pay-as-you-earn repayment, but will become eligible if the Perkins Loan is included in a Direct Consolidation Loan. Parent PLUS Loans and private student loans are not eligible for pay-as-you-earn repayment. Federal consolidation loans that refinance a Parent PLUS Loan are not eligible for pay-as-you-earn repayment, even if the consolidation loan includes a federal student loan. Federal student loans that are in default are not eligible for pay-as-you-earn repayment except as part of a loan rehabilitation agreement.
Pay-as-you-earn repayment is available for federal student loans in the Direct Loan program only. Borrowers can consolidate Stafford and Grad PLUS Loans from the Federal Family Education Loan (FFEL) program into the Direct Loan program at StudentLoans.gov to qualify for pay-as-you-earn repayment.
To be eligible for pay-as-you-earn repayment, the borrower must be considered as having a partial financial hardship. A partial financial hardship occurs when the borrower’s monthly payment under the pay-as-you-earn repayment plan is less than the monthly payment under standard 10-year repayment. In other words, if the pay-as-you-earn repayment plan would reduce the borrower’s monthly payment as compared with standard repayment, the borrower qualifies for the pay-as-you-earn repayment plan.
If the borrower is married, the determination of eligibility is based in part on the borrower’s federal income tax filing status.
If the borrower files a separate federal income tax return, such as married filing separately, the loan payment is based on only the borrower’s income and applies to only the borrower’s federal student loans.
If the borrower files as married filing jointly, the loan payment is based on the joint income of both the borrower and the borrower’s spouse, but is also applied proportionately to the federal student loan debt of the borrower and spouse.
A married borrower who files a separate federal income tax return may forgo some tax benefits that are restricted to married borrowers who file joint returns, such as the student loan interest deduction. But, the loan payments will also be lower if married borrowers file separate returns as opposed to a joint return. This is especially important for borrowers who expect to qualify for public service loan forgiveness, since it can increase the amount of debt that is forgiven.
To qualify for pay-as-you-earn repayment, the borrower must also be a “new borrower” as of October 1, 2007 and have at least one eligible federal education loan disbursed on or after October 1, 2011. For a borrower to be considered a new borrower as of October 1, 2007, the borrower cannot have any loans that were disbursed prior to October 1, 2007, nor any loans made on or after October 1, 2007 while the borrower still had loans that were made prior to that date. So consolidating loans made prior to October 1, 2007 does not convert the borrower into a new borrower.
The pay-as-you-earn repayment plan yields a lower monthly payment and may be preferred over income-based repayment and income-contingent repayment by borrowers who qualify for it. Otherwise income-based repayment is available to more borrowers who have a heavy student loan debt burden as compared with income, since it isn’t restricted to borrowers with loans in the Direct Loan program like pay-as-you-earn repayment.
As a good rule of thumb, all borrowers whose total eligible federal student loan debt exceeds their annual income will qualify for pay-as-you-earn repayment. Some borrowers with lower debt levels will also qualify, but there is no simple rule of thumb for identifying all eligible borrowers. Instead, these borrowers will need to use a pay-as-you-earn repayment calculator to determine whether they are eligible for income-based repayment.
The Institute for College Access and Success (TICAS) also provides a calculator on the IBRinfo.org site. The Direct Loan program provides a repayment estimator that includes estimates of monthly payments under all repayment plans, including pay-as-you-earn repayment, but this tool is available only to borrowers who already have loans in the Direct Loan program.