Should I Choose an Income-Based Repayment Plan for My Student Loans?

The number of borrowers who are repaying their student debt through plans based on how much money they earn has grown dramatically—up 144% in the past two years.

These plans, which are designed to reduce loan bills to a manageable percentage of monthly income, can be a huge help to struggling borrowers.

But if you aren't truly struggling to make your monthly payments, income-driven plans (an umbrella term for the group of plans tied to a borrower's income) aren’t as generous as they might appear at first glance.

“The Obama administration acts like they should be the default choice, but in fact, they were designed to be safety nets,” says Mark Kantrowitz, a financial aid expert and publisher of the scholarship website Cappex.com.

One of the biggest problems with income-based plans is that they often result in “negative amortization,” where the monthly payment doesn’t cover the monthly interest, causing your balance to grow even though you’re paying on time each month. Kantrowitz estimates as many as half of borrowers enrolled in income-driven plans are making payments that are negatively amortized.

Why does that matter if the balance on the loan will be forgiven after 20 or 25 years of payments anyway? Because current rules require the forgiven amount to be taxed as if it were income, which means most borrowers will owe the IRS between 15% and 25% of whatever is forgiven, not counting state taxes, according an article by to Alexander Holt, a policy analyst at New America.

It's possible, and some experts even say likely, that Congress will change the rules within the next 20 years when forgiveness kicks in for the first group of borrowers who are repaying under income-driven plans. But if not, then a borrower who completed a 25-year plan and still had $50,000 in debt remaining, for example, could owe the IRS $12,500 for that loan forgiveness.

“It’s not the panacea people assume it is,” Kantrowitz says.

On the other hand, for all the borrowers whose income-driven payments do cover their interest—meaning their loan balance is actually decreasing each month—many will pay off their debt years before loan forgiveness would kick in. For those borrowers, income-driven plans simply increase the overall amount they pay, since interest accrues for a longer period of time than with a standard 10-year repayment plan.

For example, if you graduated with $30,100 in debt (the average for the Class of 2015, according to The Institute for College Access & Success) and had an adjusted gross income of $35,000, you could enroll REPAYE, the newest income-driven plan, and have monthly payments that start as low as $143. Based on the government’s student loan repayment estimator, you’d pay off all of your debt under that plan in about 16 years—and have paid $7,800 more in interest than with a 10-year plan.

If your debt is unmanageable with your current income, then income-driven plans can make financial sense, especially if you expect your salary to remain low for the next two decades. The plans also can be helpful in the short-term for someone who’s just starting out, earning a modest salary and trying to pay down high-interest credit card debt. Once you're more financially stable, you can switch to a plan with a larger monthly payment.

Related: Which Income-Based Repayment Plan Is Best for You?

“The issue is most borrowers don’t know they have that option, that they can go from one plan to the other,” says Jessica Ferastoaru, a student loan counselor with Taking Charge America.

Adam Minsky, a lawyer in Boston who specializes in student debt, says that unless you’re working in public service, if you can afford to make payments under a balance-based plan (such as the standard 10-year plan or an extended-payment plan), that’s generally what you should do. Under balanced-based plans, your monthly bill is determined by the size of your balance rather than your income.

That way you’ll be making payments that you know are reducing your balance. You also won’t have to worry about your payment changing each year with your income.

To be clear: Income-driven plans are much better than deferment or forbearance. With either of those, your debt will keep growing and you won't have started the clock ticking toward forgiveness.

But if you think you'll be able to pay off your debt in full, then you won’t want to stay in an income-driven plan forever. You’ll only end up paying more overall.