How to lower your monthly student loan payment if you're worried about how to afford it when forbearance ends in January

  • Federal student loans payments have been paused and interest rates set to 0% since March. But, barring any new legislation, payments and interest will resume after December 31, 2020.
  • If you're unsure how you'll pay your loans in January, an income-driven repayment plan could help you limit your student loan costs to a percentage of your income, and forgive balances after 20 or 25 years.
  • To apply, you'll need to decide which income-driven repayment plan is right for you, and submit an application through the Office of Federal Student Aid's website.
  • It's worth noting the drawbacks, too. Financial planners say these plans can increase balances due to interest, and hand you a hefty income tax payment on any balance forgiven in the future.
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Federal student loans have been far from many borrowers' minds since March, when payments were paused and interest rates set to 0% by the CARES Act. But, those provisions will soon be expiring as the new year approaches. 

While student loan repayment is set to resume, the pandemic — and its economic effects — are far from over. Data from the Bureau of Labor Statistics estimates that the unemployment rate this month is 6.9%. If you've lost income and are worried about how you'll make payments, an income-based repayment plan could be right for you.

An income-driven repayment plan could reduce or eliminate your payment

The income-driven repayment plan program is offered to federal student loan borrowers with high payments compared to their incomes. While there are several different types of income-driven repayment plans, all work in two ways: reducing your payments to a percentage of your income, and eliminating any debt remaining after 20 or 25 years of payments. 

"I've found for awhile now that student loan balances are so high relative to salaries, that nine times out of 10, [an income-driven repayment plan] is a no-brainer for most people," says financial planner Kevin Mahoney of Illumint.

Most plans calculate payments as 10% to 20% of your monthly discretionary income, or the amount left over each month after bills and essentials. However, payments could be as low as $0, according to your family size and income. Income-driven repayment is available until your loans are paid off, and could provide lasting benefits. 

Each plan has a different set of requirements and rules, and it's a good idea to get familiar with the requirements and eligibility for each plan before applying. Once you know which plan is the right fit for you, the application is available online through the Office of Federal Student Aid.

There are some drawbacks to income-driven repayment plans

An income-driven repayment plan can help make loans more affordable for some, but they're not right for everyone. 

One of the most notable drawbacks to income-driven repayment plans is that they do have a cost in the long run. Forgiven student loans are treated as income, and will be reported and taxed as such in the year they're forgiven. For some people with high student loan balances, it's important to consider how that will affect you in the future as you'll face what's often called a "tax bomb."

Financial planners note that income-driven plans can also increase the total balance of your loans, as they're now stretched out to a 20-year or 25-year loan. "If people have relatively high balances and decide to go on an income-driven plan, they're probably not paying enough on a monthly basis to keep up with all the interest," says Mahoney. "Over that long period of time, the balance may actually grow." 

That not only adds to the amount you'll owe in eventual income tax after forgiveness, but it can also become part of the capital (the part of the loan on which interest is calculated) if you switch plans in the future.

And that growing balance might not make sense for you if you have a high-earning degree. Financial planner John Bovard of Incline Wealth Advisors in Cincinnati, Ohio, gives the example of a law school graduate he worked with.

"She just assumed that this was going to be forgiven [with income-driven repayment]," he said. "Instead of having a 10-year student loan, she now has a 25-year student loan. She was actually paying thousands of dollars more in interest than if she would've just kept her original loan of 10 years," he says. 

While they do have drawbacks, they can be helpful for those with lower incomes and relatively high student loan payments. Especially in a time of uncertainty and widespread unemployment, an income-driven plan can help you take back control of your monthly budget.

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