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What is Pay As You Earn (PAYE)? Do I qualify?

A brief history stock-exchange-and loan

To help graduate students in the United States from defaulting on their federal student loan, the government introduced a number of repayment options called income driven repayment plans.

It allows the borrower to pay a percentage of their income towards the repayment of the student loan .After making monthly payments for 20-25 years, the balance loan amount is written off.

The income based repayment (IBR) plan which was introduced in 2008, is the most popular option. It capped the monthly payment amount for any federal loan to 15% of the discretionary income of the borrower and the balance loan amount is forgiven after 25 years of prompt monthly payments.

In 2012, the pay as you earn plan by Obama administration was introduced. As per the plan the monthly payment is capped to 10% of the discretionary income of the borrower and the balance loan amount is forgiven after 20 years of prompt monthly payments.

Pay as you earn eligibility criteria

The pay as you earn student loan repayment program has specific requirements that have to be met for the borrower to qualify for PAYE. Read the below pay as you earn and self assessment guidelines before enrolling yourself for the plan.

  1. The only federal loan that is eligible is the Direct Subsidized and Unsubsidized for Undergraduates and Direct Plus for Graduates and Professionals. The direct plus loans that are taken by parents does not qualify for this program.
  2. The applicant should be a new borrower who took the loan after October 1, 2007 and taken a direct loan or direct consolidation loan after October 1, 2011.
  3. Partial financial hardship should be proved by the applicants. The details of the borrower’s income and the number of people in his family have to be furnished. The income of the members of the family will also have to be provided.

Definition of partial financial hardship

This is one of the important factors that decide if you are eligible for PAYE. It is therefore important to understand the meaning of the term.

Partial financial hardship can be shown to exist if you are making monthly payments under the standard 10 year repayment plan and the monthly amount exceeds 10% of your discretionary earnings.

Follow the below steps to check if you fall under the category.

  • Total the amount of you own from eligible federal student loans according to the 10 year standard repayment plan.
  • Calculate the difference between the adjusted gross income and 150% limit of the below poverty line guidelines specific for the sate you are residing in.
  • If the difference is greater than 10% of your discretionary income, then you can establish partial financial hardship.

Advantages of the Pay as you earn plan

Below is a brief description of the benefits of PAYE that you should consider.

  1. Monthly payments are structured on earnings

business-loanAs with other plans like income based repayment and income contingent repayment plan, pay as you earn also calculates the monthly payments based on the discretionary income. But instead of 15%, Pay as you earn plan puts a cap at 10%. The 5% reduction significantly lowers the monthly payable amount.

  1. Interest will not be accrued on subsidized loan

Pay as you earn plan protects the borrowers from interest capitalization. Interest capitalization basically means that the unpaid interest will be added to the principal amount of the loan which will make the loan expensive in the long run.

Under the Pay as you earn plan, the government will pay the unpaid interest on direct subsidized loan for a period of three consecutive years from the time the borrower begins to make payment.

  1. Loan forgiveness after 20 years

If you have secured federal loan and opted for Pay as you earn plan for repayment, you can look forward to loan forgiveness after 20 years. This is contingent on whether the borrower has made 240 full and on time monthly payments.

  1. Loan forgiveness can be obtained after 10 years

If you qualify as a public service worker you can leverage the Pay as you earn plan to its full potential. People, who work full time for an eligible public service organization that is either government run or non profit, stand a chance to received loan forgiveness after 10 years.

This is a huge advantage as the borrower can relieve himself of the federal student loan much earlier than anticipated.

Disadvantages of pay as you earn plan

Below is a brief description of the downsides of PAYE that you should take into account.

  1. Pay as you earn may cost you more in the long run

The pay as earn scheme reduces the monthly payments thereby reducing your stress in the short run. But this may hurt you in the long term as you end up paying more. This is because the tenure of the loan gets stretched and more interest gets accumulated.

For people who are focused on low monthly payments, this may not be a cause of worry. But if you are able to make the payments, Pay as you earn plan may rip you off.

  1. Submission of annual documentation is required

american-billsTo become eligible for the pay as you earn plan you have to furnish the paperwork that shows your annual earnings of each year. If you fail to do so, the unpaid interest will be capitalized. In extreme cases, the borrower may be expelled from the program.

For people who have a stable job, this may not be worrisome. But for people with unstable income, providing such proof may be difficult.

  1. Partial financial hardship is a pre requisite

In order to qualify for the pay as you earn plan it is imperative to establish partial financial hardship. This exists when the sum of money owned each year is greater than 10% of the discretionary income.

If you meet the criteria you can enroll for the plan otherwise you have to look at other alternatives to pay your federal student loan.

  1. Tax may be levied on the loan forgiven

As per the rules tax will be imposed on the amount that is written off. This may not appear to be significant at the moment but will definitely pinch you later as any loan forgiven has to be reported in IRS fillings. This will increase the amount of tax that you will have to pay for year in which the loan is forgiven. This may lead to a huge onetime tax payment.

How to enroll for pay as you earn repay?

You can enroll for free from any student loan service provider or you can directly log onto studentloans.gov and fill out the request form. You can choose your option from the many income driven plans or you can leave it to the government to pick a plan that offers the lowest monthly payment.

Pay as you earn calculator

You can calculate your monthly payment amount using the PAYE calculator which was developed by the U.S. Department of Education.

debt-paybackYou have to provide details such as:

  • The year in which the loan was taken
  • The size of the family
  • The income of the borrower along with the income of the family members
  • The total loan amount at the start of repayment
  • The duration of the loan
  • The annual interest rate
  • The state of residence

After providing the required details, the tool generates details about your eligibility and the monthly payment amount.

Pay as you earn Vs IBR

If you are still undecided whether PAYE is the best approach for you, the below table provides a brief comparison between IBR and PAYE download the PDF.

IBR PAYE
The monthly payment is capped at 15% of the discretionary income The monthly payment is capped at 10% of the discretionary income
The loan forgiveness comes into play after 25 years of on time monthly payments The loan forgiveness comes into play after 20 years of on time monthly payments
Monthly payments are high compared to PAYE Monthly payments are low compared to IBR

At the end of the loan term borrowers who have opted for PAYE will end up paying two third of the amount they would have to pay if they had chosen the IBR plan.

REPAYE- the pay as you earn expansion

Pay as you earn 2016 plan will face stiff completion from the more refined REPAYE plan. On October 27th, 2015 the Obama administration announced a major reform.

The department of education will amend the rules and allow anyone with a federal student loan to become eligible for REPAYE repayment plans from December, 2015.

REPAYE is the new improved version of the pay as you earn repayment plan. Unlike PAYE that did not allow people to enroll if they had taken the federal loan before October 2007, REPAYE does away with that clause.

The REPAYE program allows over 5 million additional direct loan borrowers to enroll for this plan and put a cap on their monthly payments to 10% of their discretionary earnings. The year in which the loan was taken is not a consideration any more.

Apart from this REPAYE will forgive the remaining loan taken for undergraduate studies after 20 years of full on time payments. For loan taken for graduate study the loan forgiveness will begin after 25 years of full, on time payments.

Another significant change is that to be eligible for IBR and PAY, the borrower had to demonstrate that he/she is not capable of making the monthly payment for the standard 10 year repayment plan.

This clause has been removed for REPAYE thus eliminating the barrier to entry. It is now become open to all and one need not wait for their debt to income ratio to reach a point to qualify for the benefits of REPAYE.

The REPAYE plan puts a cap on the monthly interest accrued to 50% of the amount owned. It also does away with tax penalties that were imposed on the loan amount forgiven under the PAYE plan.

taxes-photoWho should consider switching to REPAYE?

REPAYE is ideally suited for people in the below 3 situations.

  1. People with high monthly payment

If you are not able to make the monthly payments under your present repayment plan, you should consider opting for REPAYE. It allows you to set a limit on the percentage of income that can be used for repayment of loan.

  1. People chasing public service loan forgiveness

REPAYE is a qualified repayment plan under public service loan forgiveness. Apart from taking the advantages of the various benefits of REPAYE, consolidating your loan will help you extract more juice out of the plan.

  1. People who were not eligible for PAYE

If you had to opt for income based repayment plan since you did not qualify for PAYE, then you should seriously consider moving to the REPAYE plan. This could lower your payments by 15% in IBR to 10% of your discretionary income in REPAYE.

How much do you need to earn before paying tax?

There are three factors to consider before filling taxes:

  1. The age of the person filing the tax
  2. The income earned by the person
  3. The marital status of the person

If you are under 65 years the minimum income required is $10,300. If you are above 65 years the minimum income required is $11,850. This amount changes depending if you are the head of the household or if the person is married and filling returns jointly or separately.

Hence a careful understanding of the income tax guidelines are required to determine the exact amount your need to earn before paying tax.

save-moneyPAYE in the UK

The PAYE system in the United Kingdom refers to the method of paying taxes on your income and contribution towards national insurance. The employer deducts the amount from the wages or pension and provides the balance amount to the employee.

HMRC pay as you earn can be used to pay your debts. It will deduct money that you own to HM revenue and customs pay as you earn scheme every month. There are limits set on how much deduction is permissible.

If you earn less than £30,000 each year then HMRC can deduct up to £3,000 each year.

If you earn more than £30,000 each year then HMRC can deduct more than £3000 each year. The maximum deduction allowed is not more that 50% of your pay.

How much can you earn before paying 40 tax depends on your income. If you have a taxable income of more that £32,001 you are required to pay the higher rate of the 40% tax on the amount earned above £32,001 up to £150,000.

Conclusion

Pursing college education in premier institutions can be very expensive. The rising costs of books, accommodation and tuition fees may force you to question if it is worth all the pain.

The PAYE and REPAYE schemes introduced by the federal government are useful and effective tools to kick start your student loan repayment and remove the financial burden on students to a great extent.

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