Switching from IBR to PAYE

Update 2/2016: The DOE newest repayment plan, REPAYE is now available. For many if not most residents, REPAYE is probably a better choice than PAYE. I wrote about the pros and cons of REPAYE at length in this post. While the benefits and numbers are a bit different, the process of changing plans is the same.

For eligible borrowers, PAYE is just plain better than IBR.1By IBR, I mean the IBR that applies to nearly all borrowers that are not current MS1s. IBR for new borrowers (without any loans predating July 1, 2014) is very very similar to PAYE.

• The mandatory monthly payment is capped at 10% of discretionary income instead of 15%
• Loans are forgiven after 20 years instead of 25 (not relevant to most practicing physicians)
• Capitalized interest is limited to 10% of the original loan amount (that’s neat).
• Both are qualifying payments towards the 120 needed to qualify for PSLF
• Like IBR, the government pays interest on subsidized loans for 3 years (at this point only relevant for those with subsidized undergraduate loans, as grad subsidies are gone)
• Loans forgiven after the 20 years are taxed as income (just like IBR). Loans forgiven as part of PSLF are not considered taxable.

The financial requirement for PAYE is the same as IBR: you must demonstrate a “partial financial hardship” (i.e. the percentage/calculated monthly amount is less than the 10-year standard repayment for your loan balance), so the only difference is if your loans are eligible. You’re eligible for PAYE if you have no loans before October 1, 2007 and got at least one loan disbursement on or after October 1, 2011.

The oft-reported “downside” of income-driven repayment plans is that you will “pay more interest” over the longer term length. This is a bit of a red herring, as you are always free to send more money over to pay off your loan faster. IBR/PAYE plans allow you the flexibility to not need to make big payments; they don’t prevent you from taking prudent measures to pay down your debt. And if you’re planning on gunning for PSLF, then you won’t actually be making payments for that longer term length anyway!2It’s also not as though you could probably afford the standard repayment as a resident….

• If you are recent graduate, you should select PAYE as your payment plan and call it a day.
• If you have loans from October 2007 or older, you aren’t eligible for PAYE and need to stick with IBR.
• If you have no interest in PSLF (cynicism, short residency, smallish loans, private practice bound, etc), then you should probably refinance as soon as possible. The main substantial benefit of keeping federal loans is the possibility of loan forgiveness. Outside of that, private refinancing will save you money, and two companies now allow you to refinance as a resident.

If you’ve been out of school for a few years, you can potentially switch from IBR to PAYE. You apply to switch in the same process you use to update your loan servicer of your annual income. You go to studentloans.gov, pull in last year’s taxes, update family size, etc. Changing plans is just another choice instead of pick just “recalculating” your payments.

However, to switch from IBR to PAYE, this annoying thing happens:

If you leave this plan, you will be placed on the Standard Repayment Plan. If you want to change to a different repayment plan, you must first make at least one payment under the Standard Repayment Plan, or one payment under a reduced payment forbearance (you may request a reduced-payment forbearance if you can’t afford the Standard Repayment Plan payment).

This was presumably done to stop people from immediately jumping ship from IBR to PAYE. In practice, the “reduced-payment” requirement is $5. So you don’t need to shell over a few thousand to cover a month’s standard repayment. However, by switching out of IBR for the month, all of your accrued interest capitalizes. If you’ve been out for a few years making the typical negative amortizing IBR payments during residency, you may have a sizable chunk of accumulated interest sitting around.

A simple example:

• $200k loan @ 6.8% accrues $13.6k per year
• Assuming a $400/month IBR payment, the annual unpaid interest is $8800
• After 2 years of residency, that’s $17.6k accrued interest. After 3 years it’s $26.4k.
• Switching from IBR to PAYE after two or three years results in a new loan balance of $217.6k and $226.4k respectively. From that point on, the annual interest then increases to $14.7k and $15.4k.

So in this example, your monthly payment is reduced from $400 in IBR to around $266 under PAYE, which is great from a cashflow perspective. But now your loans are growing faster than ever (both from the capitalized interest on top of the fact you are paying down less of it).

By cutting those payments down from 15% to 10%, you’ll be taking an even bigger hit in terms of your loan growth. Keep in mind however that the interest that accrued while you were in school capitalized when you graduated, so you don’t have a ton to worry about if you’re fresh out of school or relatively close.

Which means: the reason to switch from IBR to PAYE is really best only to double down for PSLF. In order to maximize the gains of public service loan forgiveness, you want to spend the least amount possible during your 120 qualifying payments. The spiraling balance is then irrelevant because it’s going to be forgiven.

Over the long term, you lose some of that low-payment benefit for two reasons:

First, your “reduced” payment doesn’t count toward the 120 you need for PSLF. So you’ll have to make another as an attending, which could be as high as the 10-year standard repayment amount. In the example above, that’d be somewhere around $2-3k.3As a resident with the salary described above, that washes away over a year of the difference, but the more you earn, then the more you’ll save (until you cap at the standard repayment). Alternatively, you could pay the full standard repayment when you switch, but that’s guaranteed to be the 10-year amount as opposed to an income-driven amount, which may be significantly lower depending on your future salary.

Second, you’ll also lose a bit if your attending salary becomes high enough that you’re maxing out at the 10-year standard repayment and thus are paying more to handle a portion of that extra capitalized interest. In the example above, the extra $1000 will cost you around $13 a month; far less than you saved making the switch.

On the flip side, because PAYE prevents further interest capitalization due to its 10% cap, if you do lose your partial financial hardship due to your high income, at that point an IBR will capitalize a greater amount of accrued interest and then start costing more as well.

Well that’s boring. Technical details aside, the conclusion goes something like this:

• If you want to go for PSLF, do PAYE if you can, as soon as you can
• While your loan grows faster if you have to switch from IBR due to capitalized interest, it’s doesn’t matter if you’re doing PSLF. Even with an extra payment at the end, you’ll still just pay less money and get more forgiven.
• Switching from IBR to PAYE just to have lower payments will definitely result in your paying a lot more in interest over the course of your loan if it’s not forgiven and you stick it out for the complete term length (which you probably shouldn’t).
• If you don’t want to try to get your loans forgiven, then you should just refinance them at a lower rate (like yesterday).