Discretionary Income: Why It Matters for Student Loans
Although you may not know it, you probably make calculations about your discretionary income every day. From weighing the necessity of our next Amazon Prime purchase to considering the expense of eating out, most of us are conscious of how we spend the money that’s left over once we’ve got our bills covered.
But there’s another reason you should be mindful of your discretionary income: It’s an essential part of how monthly payments are calculated under income-driven federal student loan repayment plans. In this article, we’ll walk you through how the Department of Education sizes up your discretionary income and how their calculations translate to what you pay under a range of federal debt repayment programs. If you want to know how the government assesses your discretionary income to decide what you should be paying – pay attention.
What is discretionary income?
Generally speaking, discretionary income refers to the money that’s left in your pocket after your taxes, necessities, and utilities are paid for. While you can’t choose to skip rent or food for a month, more flexible expenses (such as a vacation or movie tickets) are up to your discretion – hence the term applied to this pool of cash.
Of course, the Department of Education is pretty interested in how much money of that kind you have at your disposal. When you enroll in an income-driven repayment plan, the goal is to establish monthly payments you can consistently afford – without leaving you starving or homeless. That’s why your discretionary income is the basis for determining how much you’ll pay with an income-driven option: Theoretically, your student loan payments should come at the expense of luxuries, not necessities.
How could discretionary income affect my student loans?
As we mentioned above, discretionary income is relevant to borrowers who currently utilize an income-driven repayment plan or those who are considering doing so. These plans adjust your monthly payment to reflect your income, which can help borrowers who might struggle to make payments otherwise. Additionally, after a specified period of 20 or 25 years of consistent repayment, the remaining balance of your loan can be forgiven. These plans may extend the length of time you’re repaying your loan, however, translating into higher interest paid overall.
You’re only eligible for an income-driven plan if it will actually lower your monthly payments – otherwise, you’ll remain on a standard repayment plan instead. So how does the government determine how much you should pay relative to what you make?
In basic terms, the Department of Education sets your monthly payment as a percentage of your discretionary income. But they can’t conduct a detailed investigation of your basic needs and nonessential expenses to customize your payments to your lifestyle. Instead, they use a specific calculation to assess every borrower’s discretionary income more simply. We’ll explain that calculation in more detail below.
How is my discretionary income calculated?
That might sound like a lot of jargon, but we promise finding your discretionary income is as simple as completing these steps:
How to Calculate Your Discretionary Income
Find your annual income (after taxes have been withheld)
|Step 2||Find the poverty guideline for your family size using this website|
|Step 3||Multiply the poverty guideline for your family size by 1.5|
|Step 4||Subtract that total (poverty guideline for your family size times 1.5) from your annual income|
You may notice a key shortcoming in this method of calculating discretionary income: Other than Hawaii and Alaska, every state’s guideline is the same, despite significant differences in the cost of living. Unfortunately, that’s just a bad break for residents of costlier states.
Now that you understand how your discretionary income is calculated, it’s time to learn how this figure translates to monthly payments you’ll really make under an income-driven repayment plan. Thankfully, your payment is set at a small percentage of your discretionary income – the government won’t demand all of it each month.
How is my monthly payment calculated using my discretionary income?
Before going further, let’s clear one thing up: With income-driven repayment plans, your total loan balance doesn’t influence how much you’ll pay each month. This makes sense (after all, these programs are designed to reflect what you can afford, not what you owe) but can seem counter intuitive to some borrowers. With other loans, the principal owed dictates the size of monthly payments, regardless whether you can afford them.
Conversely, your monthly payment for income-driven plans is a percentage of your discretionary income, which we showed you how to calculate above. Here’s what that percentage is for each of the major income-based repayment plans offered through the Department of Education.
The Major Income-Based Repayment Plans
|Plan||Percentage of Discretionary Income Required for Payments||Description|
|Pay As You Earn (PAYE)||10% of discretionary income||This program is available for all federal loans issued directly to students, and any remaining balance is forgiven after 20 years of consistent payments at this rate.|
|Revised Pay As You Earn (REPAYE)||10% of discretionary income||This program applies the PAYE standard to older loans as well, so borrowers who took on debt before that program’s inception can enjoy the same rate. The only distinction is the period of payments required before forgiveness of graduate school loans. Unlike with the PAYE program, graduate school debt requires 25 years of payments before the remaining balance is waived.|
|Income-Based Repayment (IBR)||10% or 15% of discretionary income||This program predates both PAYE and REPAYE – and borrowers who took out IBR loans before July 2014 will pay the price: 15% of their discretionary income and no forgiveness for 25 years. Those with IBR loans after that date will pay 10% and be eligible for forgiveness after 20 years of payments, basically the same terms PAYE and REPAYE offer. If you’re stuck at the higher rate currently, consider switching your loans over to a REPAYE plan instead for lower monthly payments.|
|Income-Contingent Repayment (ICR)||20% of discretionary income||ICR’s rate is higher than any other program, and forgiveness kicks in after 25 years. Accordingly, it’s only desirable for those who are willing to pay more every month in the hopes of paying less in interest over time. A limited segment of borrowers will be comfortable paying 20% of their discretionary income but not their standard repayment rate, however.|
While you could easily calculate your payments as a percentage of discretionary income with each plan, you don’t need to. The Department of Education offers a handy Repayment Estimator tool to assess how much your income-driven payments could be under each plan.
The tool incorporates some useful assumptions (such as anticipating your income will grow over time and, thus, projecting higher income-driven payments in the long run). Additionally, it will tell you if income-driven plans will help you pay less each month. If they won’t, you won’t qualify for an income-driven program anyway.
A Different Path to Better Payments
While discretionary income is a crucial element of some borrowers’ repayment strategies, it won’t be particularly relevant for others. Perhaps you’re looking for lower monthly payments or a better interest rate, but you make enough that you’re ineligible for income-driven plans. If that is the case, even more advantageous options may be available to you.
For those with strong credit and earnings, student debt refinancing can translate to enormous savings over the life of the loans. By securing better terms with a private lender, borrowers can keep hundreds of dollars in their pockets (an average of $259 monthly).
To learn more about the benefits of refinancing and other strategies to effectively manage student debt, explore all of Nitro's resources on the subject. We’re here to help you make the most of your investment in your education and save thousands of dollars in payments along the way.