The Pay As You Earn (PAYE) repayment plan is an income-driven repayment (IDR) plan for some federal student loans. Like other IDRs, PAYE bases monthly payments on your income and family size to keep them affordable.
How Does the PAYE Plan Work?
One of four income-driven repayment plans offered for federal student loans, PAYE was first offered in December 2012. You can apply for PAYE through your student loan servicer to lower student loan payments if you’re eligible.
But PAYE could also increase your total amount repaid as well. These lower payments will mean you’re paying less toward your principal balance each month. And since the amount you owe is also what you’re charged interest on, if it goes down more slowly, you’ll pay more total interest.
You’ll have to apply to the PAYE plan with your student loan servicer to determine if you’re eligible for this plan. If approved, you’ll also need to recertify your income each year.
Fortunately, the PAYE repayment length is limited to 20 years, with student loan forgiveness offered on any remaining balance after that.
Loan forgiveness is usually considered taxable income by the Internal Revenue Service. However, if your student loan is forgiven between 2021 and the end of 2025, the forgiveness will be tax-free, as part of the relief provided by the American Rescue Plan Act.
Pros and Cons of PAYE
Lowers payments to just 10% of discretionary income
Married borrowers who file jointly will have joint income considered when determining payments
Married borrowers who file separately will have payments based on their individual income
Forgiveness of remaining balance after 20 years
Unpaid interest on subsidized loans is paid by the government for the first three years
Only open to newer borrowers
Parent student loans, private student loans, and defaulted loans aren’t eligible
Total amount repaid could be higher on PAYE, and unpaid interest could be added to your balance in the future
Any forgiven balance is normally considered taxable income through PAYE (except for loans forgiven between 2021-2025)
How the PAYE Plan Lowers Your Student Loan Payments
If approved for PAYE, your monthly minimum payments for federal student loans will be equal to 10% of your discretionary income. For PAYE, discretionary income is the difference between your adjusted gross income (AGI) and 150% of the poverty guideline for your family size and state of residence.
Here’s an example of how the PAYE repayment plan could lower student loan payments, according to the Federal Student Aid Office:
- A single borrower with a family size of one has an AGI of $40,000, with $45,000 of student debt eligible for the PAYE plan. With an average interest rate of 6%, monthly payments are $500 under the 10-year Standard Repayment Plan.
- For borrowers living in the contiguous states, 150% of 2020 poverty guidelines is $19,140. This borrower’s discretionary income is $20,860, or the difference between their AGI and 150% of the poverty guideline.
- PAYE payments are 10% of discretionary income, which would be $2,086 for this borrower for the whole year. Divided by 12, the monthly payment is $173.83.
- If you have no income, your income is below 150% of the poverty guideline, or your monthly payments would be less than $5 under PAYE calculations—your payments are set at $0. If your PAYE payments are calculated between $5 and $10, your monthly payment will be $10.
Married Borrowers and the PAYE Plan
Borrowers who are married might have some extra considerations. Whether your spouse’s income will be included in the AGI used to calculate your PAYE payments depends on how you file your taxes. If you file separately or are separated, only your individual AGI is used to set your PAYE costs.
If you file jointly, your spouse’s income will be included in calculating your income for PAYE. But a servicer will also consider both you and your spouse’s combined federal student debt, and adjust your student loan payments proportionally to your share of the debt balance.
What Happens to Unpaid Interest on the PAYE Plan?
You could have unpaid interest accruing on student loans on PAYE if monthly interest is higher than monthly payments. In the example above, the borrower’s monthly interest charges are $225 on a $45,000 debt with 6% interest. After the $174 required monthly payment, that leaves $51 in unpaid interest.
So what happens to this unpaid interest on the PAYE repayment plan? If you have subsidized loans, the government will cover unpaid interest for the first three years you’re on PAYE.
But half of the interest on unsubsidized loans, and subsidized loans after those first three years, is your responsibility. Unpaid interest will accrue but won’t be added to your balance right away (which means you won’t pay interest on this interest). It will only be added to your balance, or capitalized, if you no longer qualify for payments based on income or you leave PAYE.
If you become ineligible for PAYE, capitalized interest is capped at 10% of your loan balance when entering PAYE. If you choose to leave PAYE, the full amount of unpaid interest is capitalized.
Requirements for the PAYE Plan
If you’re interested in this repayment plan, check out the eligibility requirements for PAYE.
- Be a newer borrower: You must not have had federal student loans before Oct. 1, 2007, and you must have a federal student loan disbursed on or after Oct. 1, 2011.
- Demonstrate partial financial hardship: The payments you would make under the PAYE plan must be less than the payments you would make on the 10-year Standard Repayment Plan to be eligible to enroll in PAYE.
- Have eligible student loans: Most direct loans and FFEL loans are eligible for the PAYE plan, except for those made to parents. Your student loans also can’t be in default.
How to Sign Up for the PAYE Repayment Plan
You can start an income-driven repayment plan application on the Federal Student Aid site or through your federal student loan servicer. You’ll need your tax information, specifically your income, to complete this application.
After submitting your application, the Federal Student Aid site or your servicer will tell you which IDRs you qualify for. You can then confirm you want to enroll in PAYE, and follow your servicer’s directions for making payments under this new plan.
Once you’re enrolled in PAYE, you’ll also need to recertify your income and family size each year with your servicer. If your income has increased or fallen, your payments will be adjusted accordingly.