What is REPAYE?The Revised Pay As You Earn (REPAYE) plan is an income-driven repayment plan for federal student loans. With REPAYE, borrowers have access to many of the same benefits and protections available under the Pay As You Earn (PAYE) plan. However, under the new plan, monthly payments are capped at 10 percent of a borrower’s discretionary income and an interest subsidy helps to prevent loan balances from ballooning due to unpaid interest.
What are the benefits of REPAYE?In addition to income-based payments, which are capped at 10 percent of discretionary income, there are three primary benefits to REPAYE: 1. The Interest Subsidy In the event that your payments don’t cover all of the interest that accrues on your loan balance in a given month, the federal government will pay a portion of the unpaid interest (usually 50 percent), which helps to reduce the amount that accumulates over time. 2. The Limited Circumstances in Which Interest is Capitalized With most types of debt, unpaid interest is capitalized (added to the principal balance) on a monthly basis. With REPAYE, interest is only capitalized if the borrower leaves the plan. 3. The Loan Forgiveness Track After 20 to 25 years of qualifying payments, any outstanding debt is eligible for forgiveness. Let’s take a closer look at each of these. The interest subsidy and the limited circumstances in which interest is capitalized Under most repayment plans, including the Standard, Extended, and Graduated plans, monthly payments are set high enough to cover all of the interest that accrues in any given month. Since REPAYE payments are determined with respect to a borrower’s income and can be as low as zero dollars each month, payments may not always cover the interest that accrues during the month. In the world of finance, this is known as negative amortization. This is where the interest subsidy and the limited circumstances in which interest is capitalized become important. The interest subsidy For borrowers with subsidized loans, the federal government will pay 100% of unpaid interest for the first three years and 50% of the unpaid interest that accrues each month thereafter. For borrowers with unsubsidized loans, the subsidy is equal to 50% of unpaid interest at all times. The limited circumstances in which interest is capitalized When interest is capitalized, it is added to the principal balance. This, of course, increases the loan balance which, in turn, increases the amount of interest generated in the following period. However, under REPAYE, unpaid interest isn’t capitalized on a monthly basis like it is with many other types of debt. In fact, interest is only capitalized in a couple few very specific instances: (1.) if the borrower voluntarily leaves the plan or (2.) she fails to recertify her income before the annual deadline. Essentially, unpaid interest is recorded, but it exists in a separate column, so to speak, and is not added to the principal balance while the borrower remains enrolled in REPAYE. This means that the loan balance will grow, but it won’t grow exponentially as loans subject to compound interest do.
EXAMPLE SCENARIO Let’s assume that our borrower’s starting balance is $40,000 and that the interest rate on her loan is 5.31%. Under the Standard Plan, she’d owe $430.35 each month. At the start of her repayment plan, out of that $430.35, $177 goes to interest. Let’s say that she qualifies for a $120 payment under REPAYE. In month one, the amount of unpaid interest is equal to $57. If this were a typical loan, that $57 would be capitalized (added to principal balance), and interest would be calculated using the new total (i.e., $40,057). So, in month two, she’d owe slightly more in interest ($177.25), because, again, the principal now includes that extra $57 in unpaid interest. Each month that there’s unpaid interest, the principal increases, and along with it the interest owed. There’s a cumulative effect. Now, remember, with REPAYE, unpaid interest isn’t capitalized unless the borrower exits the program. So, the principal, which is used to calculate interest, remains at $40,000. Some unpaid interest will accumulate, but the rate at which it accumulates won’t increase. What’s more, borrowers enrolled in REPAYE are eligible for an interest subsidy, which typically covers half of unpaid interest.