Income Based Repayment Won’t Solve the Student Loan Crisis

When President Obama delivered new rules on income based repayment (IBR) for a limited group of borrowers back in 2013, we wrote about the shortcomings of that program. This week, the President extended the new IBR program to cover all borrowers, effective in 2015. It’s the same program as before, and while it can provide payment relief to some borrowers, it has some serious drawbacks. Notably:

• The program is only applicable to borrowers with high debt relative to their income
• The program can result in borrowers paying much more in interest and taxes over the life of their loan
• The program masks the real culprit here – why people are graduating with so much debt to begin with

Here’s how to calculate payments under the new IBR program:

1. You take your salary and subtract the sum of your standard tax deduction (which is probably $6,100) and 1.5 times the poverty wage rate for your state (which unless you live in Alaska or Hawaii will be about $17,505 for someone filing single).
2. Multiply that number by 10% and divide by 12 to calculate your monthly payment.

If you make $75,000/year, your maximum payment is ($75,000-$6,100-$17,505)*.1/12, or $428.29 a month. That corresponds to $37,200 in loans at a 6.8% interest rate. The following chart shows IBR relevance for different debt/income combinations.

For example, if you make $35,000 a year, IBR is relevant if you owe more than $8,900.  If you make $125,000 a year, IBR is relevant if you owe more than $72,772.

I use the term “relevant” versus “helps” because even if you are eligible for IBR, it isn’t always a wise decision to use it.  IBR doesn’t change your loan rate, so while your payments might go down, you could end up paying significantly more interest over the life of your loan and/or face a significant tax bill when any outstanding balance is forgiven after 20 years.  Let’s assume you have $37,200 in debt, like the first example above, but only $60,000 in income (and you get a 3% annual raise).  IBR is relevant, but if you elect it you will be paying off your loan for 155 months (versus 120) and paying $5,930 more in interest.

However, if you have the same debt, but only $35,000 in income, IBR will actually saves you $11,138 over the life of the loan.  Why?  Because you never fully pay the loan off, and in 20 years the remaining balance is forgiven (with a tax consequence).  The following table shows the debt/income combinations where IBR saves a borrower money over the life of the loan.

Whereas the first chart shows relevance, this chart shows something akin to “better” and “worse”. In certain circumstances, IBR clearly saves the borrower money, even over the life of the loan. However, while IBR can also increase the time it takes to pay off your loan, increase your lifetime interest costs and give you a large tax bill after 20 years. Note that this impact is even more pronounced when you compare using IBR versus refinancing your student loans at a lower rate with a lender like SoFi.

For example, assume you have $100,000 in debt at a blended rate of 7%, and make $125,000 a year. If you elect IBR (using the assumptions above), you would start off with an $844 monthly payment that grows to almost $1,200 over the life of the loan (because your income is growing). You will pay $51,857 in lifetime interest. Or you could refinance with a SoFi 15-year loan at 6%, make the same monthly payment of $844 for the life of the loan and pay $41,263 in lifetime interest – $10,594 savings versus IBR. Lowering your loan rate can be a much better strategy than reducing your monthly payments using IBR.

Regarding my final point, at SoFi we help borrowers with the burden of the student loan crisis every day. While I applaud efforts to address borrower hardship (though we’d prefer greater transparency, like I’ve provided in this document), I’m frustrated with the constant focus on the symptom, not the cause. Why are individuals graduating with debt burdens that they can’t service? Why has tuition – and debt loads – risen far faster than the rate of inflation? Ultimately this comes back to the Department of Education’s lending policy, something we’ve written about before.

Lowering interest rates or payments is a band-aid; we need a cure. Force the schools to charge tuition that is commensurate with the value of education, and provide all borrowers financial literacy explaining what their degree is worth and how much they can borrow given their career prospects. Otherwise despite the government’s good intentions, we’re in a system that is doomed to fail, and fail in a big and far reaching way.