There are 3 major disadvantages to income-based repayment:
- You’ll be in student loan debt longer
- You’ll pay more in interest
- You’ll get hit with a tax bill at the end of the plan.
Two other minor disadvantages are that you have to apply for an IBR plan each year and your monthly payments could be a lot more than if you paid your loans off in 10 years.
#1 You’ll stay in student loan debt longer
The income-based repayment plan is one of 4 loan repayment plans based on your income the Department of Education offers:
- Income-Based Repayment (IBR)
- Revised Pay As You Earn (REPAYE)
- Pay As You Earn (PAYE)
- Income-Contingent Repayment (ICR)
Each repayment option limits your monthly payment amount to a percentage of your discretionary income.
Discretionary income is the difference between your adjusted gross income (AGI) and your family size.
In exchange for offering the lower monthly payment, the government stretches your student loan repayment from 10 years to 20 to 25 years.
As a result, you may end up paying your student loans at the same time you’re trying to help pay your children's education debt.
#2 You’ll pay more in interest
The longer you have your federal loans, the longer time your interest has to accrue. And the more time your interest has to accrue, the more you’ll pay in interest.
Federal student loans are particularly brutal when it comes to interest: they start accruing interest from day one.
And once they start accruing interest, they don't stop.
On top of that, federal student loan interest is calculated on a daily basis. Depending on your interest rate, your loan balance can double or triple while you’re in the IBR plan.
So what should you do? Stay in the IBR plan or pay your loans off faster?
The answer depends on a host of factors:
- Your age
- Loan balance
- Annual income
- Family size
Typically, my advice is that the larger your loan balance and the smaller your income and retirement/savings, the more inclined you should be to stay in the income-based repayment plan.
#3 You may have a large tax bill
At the end of the income-based repayment plan, your entire loan balance will be forgiven without limit.
While getting rid of your student loan debt sounds great, the problem is that you’ll be swapping one debt for another.
The IRS will treat the forgiven balance as taxable income when you file your next income tax return.
The Public Service Loan Forgiveness Program is different. While loan forgiveness under the IBR plan is treated as taxable income, the loan amount that's forgiven under the Public Service Loan Forgiveness program is not treated as taxable income.
Under current tax law, you can avoid paying taxes on the forgiven balance by applying to have the balance excluded from your income.