[Editor's Note: This guest post was submitted by student loan expert, financial advisor, and skier Daniel Wrenne, CFP CLU, ChFC, CFP. Rumors about me leading Daniel over a cliff while skiing together in Utah could be true. Wrenne Financial Planning is a long-time advertiser on this site. Today's post involves the government student loan programs and specifically when the Pay As Your Earn (PAYE) program may or may not make sense.]
It’s been said many times that with Public Service Loan Forgiveness “PSLF”, the Pay As You Earn “PAYE” repayment plan always works best. In fact, many consider it a rule of thumb. But did you know that using this rule of thumb could cost you over $60,000? I am writing this to share with you a sneaky exception to the rule that you should know about.
So that we are all on the same page, let me clarify the rule of thumb I’m talking about. Here is the logic. PAYE and RePAYE are very similar. Both are income-based. Both qualify for PSLF. Both set your payment at 10% of discretionary income. However, PAYE has a couple of major advantages over RePAYE that swing the pendulum in its favor.
Review: PAYE vs RePAYE
#1 Payment Cap
PAYE payments are capped at the 10-year standard payment whereas RePAYE payments have no cap.
You have the option to file taxes separately and exclude your spouse's income from your PAYE calculation. With RePAYE both spouses’ incomes are always included even if you file taxes separately.
#3 Interest Subsidy
The only big advantage RePAYE has over PAYE is the unpaid interest subsidy. However, if you’re going for PSLF, interest is typically irrelevant.
Given these facts, it would make sense for everyone going for PSLF to use PAYE because it has everything RePAYE has plus more, right? That’s the rule of thumb. And it works well… most of the time. But not always! Before we talk about the exception to this rule, let’s make sure the RePAYE and PAYE math is clear.
Here is the actual formula:
RePAYE and PAYE annual payment = (AGI – 1.5 x poverty level) x 10%
Let’s see how this works for John. John is an in-practice pediatrician making $150,000 per year (AGI), has $150,000 in federal student loans, is going for PSLF and is currently in PAYE. He wants to make sure this is still the best option and is comparing repayment plans. For simple math, let’s assume that based on his situation, 1.5 x poverty threshold is $20,000. (The actual number depends on your family size, current year poverty guidelines and sometimes the state you live in.)
Here is the math for John:
($150,000 – $20,000) x 10% = $13,000
John assumes that because the formula is the same for RePAYE and PAYE his payment will also be the same under both. But when he runs the numbers using the federal student aid calculator, he finds this is far from true. The RePAYE payment is $4,500/yr and PAYE is $13,000/yr. His PAYE payment makes sense. But what’s up with the RePAYE numbers?
Oh, I forgot to tell you. John is married to a resident physician earning $50,000 (AGI). His wife, Janet, is also going for PSLF and owes $450,000. She is set up with PAYE as well and they have been filing taxes as married filing separately “MFS”. So, under PAYE, her situation has no effect on his payment calculation. But with RePAYE, it totally changes the formula.
Here are better formulas:
Single RePAYE/PAYE or Married filing separately PAYE annual payment
= (Individual AGI – 1.5 x poverty level) x 10%
Married filing jointly or separately RePAYE and Married filing jointly PAYE annual payment
= (Household’s AGI – 1.5 x poverty level) x 10% x (Spouse # 1 total loans / Household total loans)
RePAYE (and PAYE filing jointly) repayment plans force you to include your spouse's income and loans. They calculate your payment as if you have one combined household income and one big joint student loan. And then they split the household payment up proportionate to each borrower’s percentage of the total debt. Keep in mind that the PAYE payment is capped at the 10-year standard payment and the RePAYE payment has no cap.
Here is the actual RePAYE math for John’s RePAYE (and PAYE filing jointly) annual payment:
($200,000 – $20,000) x 10% x ($150,000 / $600,000) = $4,500
Now that the math is clear, let’s look at Janet’s PAYE and RePAYE payments.
Janet’s PAYE (MFS) annual payment:
($50,000 – $20,000) x 10% = $3,000
Janet’s RePAYE annual payment:
($200,000 – $20,000) x 10% x ($450,000 / $600,000) = $13,500
The key for couples that intend to stay married is they must look at all the household total payment scenarios. In order to figure all the scenarios, they must run all individual combinations and add them together to come up with the total household payment. Here are their household total numbers for the two scenarios we’ve talked about so far:
#1 John and Janet PAYE (MFS) = $16,000
#2 John and Janet RePAYE or PAYE (MFJ) = $18,000
The Exception to the PAYE Rule
Most people get this far and they end up selecting PAYE for both because it gives them the option to file separately and cap payments. But what if they don’t use the same repayment plan?
#3 John PAYE and Janet RePAYE = $26,500
That’s no good. You can see how someone could really mess this up if they’re not clear on how the formulas work or get led astray by an ignorant loan servicer.
#4 John RePAYE and Janet PAYE (MFS) = $7,500
We have a winner! This option ends up being a home run for John and Janet. John uses RePAYE to leverage Janet’s much higher debt to income ratio. Janet uses PAYE/MFS to exclude John’s much lower debt to income ratio. They get the best of both worlds.
Confusing right? Student loans today are totally counterintuitive. Do the math yourself and work through the logic. It seems like some people get the whole income-based part of all this. But they’re missing how the spousal debt ratios play into it.
Student loans today are totally counterintuitive. Do the math yourself and work through the logic. It seems like some people get the whole income-based part of all this. But they’re missing how the spousal debt ratios play into it. — Daniel Wrenne
Curious how the numbers play out from now until PSLF? Here are our projections for the various scenarios over the next 10 years. Keep in mind, these numbers are based on the actual poverty guidelines, therefore, the year 1 payments will differ slightly from our round numbers example above. You can see all the assumptions we used at the end of the post.
As you can see from these projections, there is a lot at stake! The swing in total payments with their current plan and the best plan is over $60,000. And the swing in the worst and best scenarios is just under $190,000 (minus the tax costs of filing separately instead of jointly)!
In order to run these projections, we had to make several assumptions.
- We assumed John has 24 PSLF qualified payments, Janet has 0 and they both make PSLF qualifying payments every month while employed full time at a PSLF qualified employer.
- We used the 2019 poverty guidelines for the lower 48 states and assumed it increases by 2.35% per year.
- We assumed family size is 2.
- John’s adjusted gross income “AGI” is $150,000/yr starting in year 1 and increases by 3% every year.
- Janet’s AGI is $50,000/yr starting in year 1 and increases by 3% every year until she goes into practice at the end of year 5. Starting year 6, Janet’s AGI increases to $250,000/yr and inflates by 3% per year.
- We used each year’s assumed AGI to calculate the same year’s IDR (Income-Driven Repayment) payment whereas in reality there is likely a lag due to using tax-return method for verifying income.
- To simplify, we also assumed that both start with $0 accrued interest.
- Both have one direct unsubsidized consolidation loan.
- Both have an interest rate of 7%.
- Projections are missing part of the all-in cost component because they do not account for the tax costs associated with filing taxes separately instead of jointly.
[Editor's Note: Interesting little twist huh? Every time I find one of these I wonder how things always get more complicated when the government gets involved. If you need some help running the numbers, check out our recommended advisor page and our recommended student loan specialist page here. If you're an attending already (and maybe even if you're still a resident) and not going for forgiveness, or if you're a resident with private loans, you need to refinance those suckers. Rates are at historic lows and even if you refinanced just a few months ago, it's probably time to do it again. Use the WCI negotiated deals below to support this site, save thousands in interest, and even get a few hundreds bucks cash back, all for just a few minutes of work. If you haven't done it yet, it's probably the best-paying thing you'll do today, even if you're a spine surgeon.]
New Bonus Disclosure
Earnest Welcome Bonus Offer Disclosure: Terms and conditions apply. To qualify for this Earnest Welcome Bonus offer: 1) you must not currently be an Earnest client, or have received the bonus in the past, 2) you must submit a completed student loan refinancing application through WCI link; 3) you must provide a valid email address and a valid checking account number during the application process; and 4) your loan must be fully disbursed. The bonus will be automatically transmitted to your checking account after the final disbursement. There is a limit of one bonus per borrower. This offer is not valid for current Earnest clients who refinance their existing Earnest loans, clients who have previously received a bonus, or with any other bonus offers received from Earnest. Bonus cannot be issued to residents in KY, MA, or MI.
“*Offered terms are subject to change and state law restriction. Loans are offered by CommonBond Lending, LLC (NMLS # 1175900), NMLS Consumer Access. If you are approved for a loan, the interest rate offered will depend on your credit profile, your application, the loan term selected and will be within the ranges of rates shown. If you choose to complete an application, we will conduct a hard credit pull, which may affect your credit score. All Annual Percentage Rates (APRs) displayed assume borrowers enroll in auto pay and account for the 0.25% reduction in interest rate. All variable rates are based on a 1-month LIBOR assumption of 0.15% effective Oct 10, 2020 and may increase after consummation.”
What do you think? Are you married to another earner and trying to figure out which IDR to use? Which program did you end up in? Comment below!