PAYE vs REPAYE: interest capitalization cap better than interest subsidy?

The PAYE interest cap is essentially never better than the REPAYE interest subsidy. There are reasons PAYE can be a better choice for many borrowers, but the interest capitalization cap isn’t really one of them.

But let’s take a step back: If you’re reading this post, you may already know the relevant facets of income-driven repayment plans that I’m referring to: Within the PAYE plan, any accrued interest that capitalizes is limited to 10% of the original principal amount when you enter repayment. What this means is that no matter how much interest accrues, the maximum principal amount after capitalization in the long-term is the original amount + 10%. Which means that over the long term, the rate of interest accrual is capped (but not the amount, of course). When does interest capitalize within the PAYE program? When you lose your partial financial hardship, which will likely happen at some point during attendinghood depending on how much you owe vs. how much you make. An example would be if you had a $200k loan with $50k in accrued interested; after capitalization in PAYE, the loan would be $220k with $30k in accrued interest instead of $250k, which means at 6.8% $14,960 accrues per year instead of $17,000.

In contrast, REPAYE has a subsidy that pays half of the unpaid accrued interest on a monthly basis. The reason the above question is basically never is because REPAYE interest never capitalizes unless you leave the plan. Because there is no hardship requirement, your interest will continue to accrue at the same rate it always has. Only if you try to change back to a different repayment plan (say, to lower payments as a high-earning attending) would your interest capitalize. That $200k loan in REPAYE will always accrue the same amount of interest every year (until you begin to pay down the principal, of course).

So when does PAYE beat REPAYE then?

For single people or married people filing jointly, PAYE and REPAYE payments will be the same (10% of AGI) until income rises high enough such that 10% of your income is greater than the 10-year standard payment calculated based on your original loan amount when you enter repayment, at which point PAYE caps at that amount while REPAYE continues to grow with growing income. So big money means bigger payments. This is actually good from the perspective of minimizing the amount of interest that accrues while paying your loan off and thus saving money overall but bad from the perspective of minimizing payments for possible loan forgiveness or to fund your high-rolling lifestyle.

The other difference between them comes if you rely on filing taxes separately from your spouse in order to get low payments with PAYE, a trick/loophole closed by REPAYE.

So PAYE will frequently “beat” REPAYE in two scenarios:

  1. A spouse earns a significant income without holding significant student loans.
  2. When your income rises beyond the “cap.” For a $200k loan at 6.8% for example, that amount is around ~$295,000 a year for a single filer.

You can run these scenarios easily in the official repayment estimator (just look at the first monthly payment). When either of these situations is about to happen while in REPAYE, it’s permissible to switch to PAYE (if eligible) or IBR (if that still works out in your favor). Note that switching to PAYE/IBR to avoid the spousal income issue requires that you file taxes separately and then submit your IDR income certification paperwork, so you can’t simply do this right before you start a new job without some planning. Bottom line: the likelihood of PAYE being better than REPAYE in the future isn’t necessarily a reason to avoid REPAYE in the present if it otherwise makes sense. See this post about switching back.

What about over the long long term, like 20 vs 25-year forgiveness?

Ah, yes, the super long term baked-in forgiveness that sounds perfect for someone with $500k in student loans who wants to work part time making $150k forever. Before we get into this scenario, please note: if you can get your loans forgiven via PSLF, then all of this is irrelevant and you’d save a ton of money. Your goal for PSLF should be to pay as little as possible per month during the 120 required monthly payments.

In the above example, your salary is never big enough to pay more than the accrued interest, so you’d think REPAYE wins. A 500k loan at 6.8% accrues $34k in interest each year. The monthly payment at a $150k salary is $1102 ($13,224/year), meaning your loan continues to grow big time forever. You never lose your partial financial hardship—thus making the PAYE interest capitalization cap irrelevant—but the interest subsidy with REPAYE will significantly reduce the growth of the loan (and subsequently the tax you would owe when forgiven). Unfortunately, the wrinkle is in the extra five years you would need to qualify for forgiveness: 20 years in PAYE and 25 years in REPAYE or IBR:

With a starting salary of 150k increasing at 5% per year, the federal repayment estimator projects PAYE forgiveness of $728k after 20 years and REPAYE $559k after 25 years while making payments of $451k for PAYE and $656k for REPAYE. At a 28% marginal tax rate for a single filer, for example, that’s a tax bill of $203k for PAYE and $156k for REPAYE for the forgiven amount due in one big lump sum. So that’s a total of $654k with PAYE and $812k REPAYE. Because REPAYE takes longer, you pay $158k more with REPAYE. With either one, you’ll need to save for years just to pay the taxes that will come due with the forgiveness (and even with your loans “forgiven,” you’re still spending a ton of money on them).

So that’s the long-term scenario in which PAYE beats REPAYE for a single filer or non-working spouse: purely due to the 5 fewer years to qualify. But as always, these calculators make assumptions that might not be true nor reflect your options.

In this scenario, you’d theoretically maximize your benefits by being in REPAYE as long as you have an interest subsidy and then switching to PAYE while still eligible once you earn too much for the subsidy (if PAYE-eligible in the first place, of course). In this case, you’d get the best of both worlds: your months in REPAYE should still count toward the 240 needed for PAYE forgiveness, but you’re also decreasing the amount of interest accrued as much as possible. If your REPAYE payments are never able to cover interest while in REPAYE, you’d stay in REPAYE until you near the 240 needed for PAYE and then switch right before. If you’re married and your spouse works, then you need to do the math with the calculator to see if your higher REPAYE payment (hopefully still with a subsidy) is better or worse than a lower PAYE without a subsidy coupled with any additional tax hits from filing separately. The bigger your loan and the less your spouse earns, the more likely the former is better. Also, unpaid interest does capitalize when switching out of REPAYE (another reason to switch as late as possible).

If switching like that sounds too good to be true, see #28 from the official FAQ:

Similarly, if you were previously in repayment under one income driven repayment plan and later switched to a different income-driven repayment plan, payments you made under both plans will generally count toward the required years of qualifying monthly payments for the new plan.

Your servicer may not agree, but servicers are often completely wrong. See an analogous verbiage within the actual REPAYE regulations (page 67222):

The statutory provisions that govern the ICR plans (which include the Pay As You Earn repayment plan, the ICR plan, and the REPAYE plan) and the IBR plan specify the types of payments that may be counted toward loan forgiveness under these plans. Generally, qualifying payments are limited to those made under one of the income-driven repayment plans, the standard repayment plan with a 10-year repayment period, or any other plan, if the payment amount is not less than the payment that would be required under the standard repayment plan with a 10- year repayment period.

So talk it out, make sure they know what feds say, and get to the bottom of it. But do that before you a make a decision that will haunt you two decades in the future. Obviously, no one has done this yet because no one is even close to having their loans forgiven yet at all, let alone in clever ways.

And lastly, note that while 20 years is a leisurely payment schedule, you’d probably still spend less money just paying it down faster. Refinancing that $500k loan even to 5% with a 10-year term would cost you around $636k to pay off (though it would also cost you $5000 a month, ouch), and all it takes is a bump in your salary to throw off your clever plan. Get it down to 4% and you’re looking closer to $607k.

As always, you’ll have to run some scenarios for yourself, but if you’re considering long-term long forgiveness, hopefully this gives you some food for thought.

20 Comments

  1. Ben, great post…thank you. I just started my intern year of residency and have $240,000 in medical school loans (~208,000 principal, 32,000 interest). All of my loans are Stafford/GradPLUS federal loans. I am planning on doing REPAYE and am in a 5 year residency with a likely 1 year fellowship. Hoping for PSLF, however, willing to refinance at the end of my training depending on my future practice situation.

    I have close to 10K saved up. Would this money be better served going towards my loans now, before my interest capitalizes with my principal at the end of November, or would it be better served going into my Roth IRA/403b?

    Thank you!

    Reply
    • If you are planning on or seriously considering PSLF, don’t put any more money toward your loans than you need to for your scheduled monthly payments. It would just be a wasted effort toward reducing an amount that would be forgiven anyway. So that 10k before capitalization would save you $680/year if your interest rate was 6.8%, but that $680 would be forgiven by PSLF so who cares?

      You may find my post on saving for retirement during residency helpful.

      You should max out the employer match on your 403b if you have one. If you need the cashflow from your paycheck and won’t be able to max it, then use your savings to make up for that. The rest (up to 5,500) can go into the Roth IRA. For this first year where your income is super low, the Roth benefits are substantial (i.e. you’re probably in the 15% tax bracket). In future years, you may decide to opt for pretax retirement contributions instead of a Roth option: but are valid, but a pretax contribution will reduce AGI and thus reduce your REPAYE payments further, helping you save even more money while working toward PSLF.

      Reply
      • Thanks for the quick response.

        From your other post “The exceptions to using that income to pay down your loans is if you’ve already saved up a 2-3 month emergency fund and are making supplemental income you don’t need but are attempting to qualify for PSLF or are getting a nice interest subsidy from the REPAYE program. In this situation, you don’t want to pay down your loans directly. Any dollar you spend toward your loans is another that won’t be forgiven for PSLF or at the least could get in the way of your REPAYE subsidy.

        Given the amount of my loans, I would assume that my REPAYE interest subsidy would be considerable, and, thus, contributing towards my loans wouldn’t be as advantageous as putting money into my Roth IRA/403b?

        Thanks again.

      • Correct.

        If the goal is PSLF, it doesn’t even matter if you get a subsidy at all, that would be money wasted. But yes, if you’re in REPAYE, extra money toward loans means less unpaid interest accrued and thus less subsidy. So extra payments means you’re raising your effective interest rate. See this post about REPAYE if you haven’t already. It’s not hard to calculate the actual subsidy.

        If one was going to pay down loans yourself and not considering PSLF, it would make more sense to save the extra money in a CD, interest-bearing savings account, or other stable safe investment until the subsidy is no longer relevant and then put that money toward your loans.

  2. Do you think that PSLF will be there in 10 years to forgive physicians that have large amounts of debt but are paid in the lower ranges (PCP, peds, etc.)?

    Reply
    • My guess is that the program will still be available to current students and residents who’ve already borrowed money and made plans that rely on it. I think in 10 years, future borrowers will have access to a limited version, most likely with the $57,500 that has been floated around in the budget proposals for the past couple of years.

      Reply
  3. Hey Ben,

    I built a student loan calculator that I used to look at PSLF vs private refinancing for my girlfriend who was just finishing up her fellowship in urogyn. It ended up getting over 300,000 views on Business Insider. I neglected to include the option to use accruing interest for PAYE and instead treated the interest as capitalizing every year. I’d love to chat if you wanted to reach out to me by email to set something up: travis AT studentloanplanner DOT com

    Reply
  4. My question is, if I switch from REPAYE to PAYE, do I still get the capitalization cap? As far as I understand, when you switch from one plan to another, you get fully capitalized.

    Reply
    • You are correct, you do not because the capitalization doesn’t happen “in” PAYE. The cap refers to a limit on capitalization that occurs as a result of losing your partial financial hardship.

      Most people who are switching from REPAYE to PAYE are doing it maximize PSLF benefits—in which case you don’t care. For long-term forgiveness, it depends more and you can do the math, but a brief period of capitalized interest at the end won’t undo the long-term benefits of lower payments until the switch.

      If you’re doing it to reduce payments in the context of a working spouse or increasing salaries but aren’t going for forgiveness, then you’re resigning yourself to substantially more wasted money on interest. If you have to you have to, but this is not the ideal scenario.

      Reply
  5. I’m looking for advice for my situation: I am fortune to have only about 70k in unsubsidized loans, about to start repayment. I am an intern (3 year program) that plans on marrying in the next 1.5 years (her income about 80k, no loans). The way it looks, my 10% AGI will be just under my interest on my 70K. So my understanding is a little interest would be subsidized with REPAYE, or a little adding-up with PAYE? That makes REPAYE sound a bit better now, but having a hard time conceptualizing how it would play out more long term. In a year or so, that REPAYE subsidy will be gone due to her income, however my payment X now = X +(some interest) with PAYE. With PAYE, a little interest would be adding-up, but I would at-least have the option to have lower due-payments the next couple of years.

    Reply
    • I’m guessing with your salary your REPAYE payment for the next year falls like $100 short of your interest amount, which means you’re talking about forgiveness of $50 bucks a month. Not a deal-breaking sum either way. Your payment will only be higher with REPAYE than PAYE if you were to choose to file taxes separately from your future spouse, which is probably not worth it tax wise.

      The “correct” choice is that outside of a REPAYE subsidy as you get settled in residency and get married, you shouldn’t be trying to minimize payments, especially with a loan that small. If you and your spouse are pulling in $130k+, then you should be refinancing to a lower rate and trying to pay down your debt. Given how small your REPAYE subsidy is, your effective interest rate isn’t much less and you’d probably save more money by refinancing. If you really want the flexibility of lower monthly payments, there are several companies that have reduced payments for residents.

      Most residents should be in REPAYE. But the fortunate few with small loans like you are exactly the kinds of folks with the most to gain from refinancing in residency.

      Reply
  6. I’m SO glad I found this website – both the information you initially provided plus your interactions with others have provided me some much-needed insight and information.

    Here’s my situation – I’d love to have your opinion. I’m a public school teacher in Texas. I’m embarrassed to say I have just over $100,000 in loans from undergrad and grad school. I’ve been on REPAYE for about 1.5 years or so. My goal is to get the debt forgiven through PSLF since I am a teacher. — I got married this past year. She has no student loan debt (lucky her). I make around $54,000 after taxes (and no hope for any kind of wage growth since I’m a teacher) and she makes about $34,000 after taxes – so about $88,000 combined after taxes.

    My payments have been affordable in REPAYE. However, things are (possibly) going to change after this year since I got married. Under REPAYE, which looks at both spouses income combined, regardless of how you file (yet I still need to file married but separately). My monthly payments go from like the mid-to-upper $200’s to close to $600/mo with my Spouse’s income included. That is not affordable with our incomes. If I switch to PAYE the payment goes down to basically the same rate as filing my taxes as single. So, I’m greatly considering moving over to PAYE which my loan servicer did say I qualify for. At the same time, I am wondering what will happen with the outstanding interest the government has been subsidizing as my current payments do not even cover the interest – will it capitalize? If so, since I’m only 1.5 (2.5 as of next year when the government looks at my income again). I think paying $500 less a month should make it worth the capitalization given my income.

    Now, the wrench that has been thrown into the works is that (as you likely know) Texas is a community property state. Which means when I file my taxes the state of Texas already considers our income joint. We can still file separately but the state, as far as I know and have done my research, says if we are filing married but separately, we have to add our incomes together and divide by two. So, we made $88,000 this year – so we each made $44,000. Well, that’s bad for my wife’s tax return she will either get nothing or have to pay in around $180 or so because that moves her into the higher tax bracket (from 12% to 22%) and she only paid taxes for her $34,000 income, not the $44,000 AGI she has to put on her taxes. Myself, on the other hand should get a larger-than-normal like an estimated $4400 refund or so (I guess it balances out) since I payed in for $54,000 but only had a $44,000 AGI. This *potentially* could help us in the long run if the government/fed loan people look at my income taxes next year and see that my adjusted gross income is $44,000 (instead of $56,000). The federal loan repayment calculator has my payment going down into the mid $100’s for PAYE using the $44,000 AGI.

    I’m just wondering your thoughts on this complicated situation keeping in mind that:
    – I’m a teacher, my wages will grow incredibly minimally
    – I qualify for Public Service Loan Forgiveness
    – Spouse has no loan debt
    – I make nearly double what my spouse makes
    – Texas’ community property / income
    – Moving to PAYE from REPAYE (unpaid interest capitalization)

    Reply
    • The capitalized interest from the switch will be irrelevant if it’s all forgiven after 10 years. The only thing that matters with PSLF is how much you actually pay over the 120 payments, which as you know will be less if you MFS. Given the monthly payments you’re talking about vs the forgiveness amount, the tax consequences will be a far second fiddle to the amount at play for forgiveness. Just don’t quit that job.

      Reply
  7. Ben,
    My wife and I are both PTs who are 2 and 3 years out of grad school. I currently have 170k in student loan debt and am close to 3 years in at a qualifying employer for PSLF. My wife has roughly 105k in student debt. We are both on income driven repayment plans. We both earn grossly 65k each. I am trying to figure out if it makes more sense for us to aggressively pay her debt off, or pay the minimum payments and wait the 20 years under PAYE? We filed jointly this past year for first time and her minimum monthly payment went to 800 dollars recently.. would it make more sense for us in this scenario to file jointly or separately with regard to keeping my payments towards PSLF as low as possible?

    Thanks,
    AJ

    Reply
    • Wow I just read this comment and I’m in a similar situation. I’m a PT as well but my loans are 215k and only a few months into the PAYE plan. I don’t think with my salary I can realistically pay this debt off. I have seriously looked at everything from the different Income repayment plans to aggresively investing and if I lose it all…. then just ill renounce my citizenship lol but not kidding it’s impossible. I mean it’s crazy but I think I have fallen into a weird hole and I don’t see any way out of it with these predatory interest rates I have 7% avg. My best estimate of monthly payments projected to 20 years I could end up with a 200k tax bill in 20 years. Any idea of how they allow us to pay this…. can it be over time? Another possibility I have considered is defaulting and just working until the IRS puts a lien on my professional license and then just disappearing off the face of the earth.

      Reply
      • Tim,

        If your balance is 4x your income, then you probably shouldn’t be in PAYE. Unless you have a high earning spouse, you’re likely to get a significant effective interest rate reduction in REPAYE. You can switch back to PAYE later if needed if you still qualify to hit forgiveness at 20 instead of 25 years.

        You should seriously consider trying to get a PSLF-qualifying job, which solves this issue.

        If you really want to move abroad, the foreign income exclusion would effectively reduce your payments to $0. You’ll still owe taxes on the forgiven amount, which you would have to save for over the next two decades.

        I would suggest you not default.

    • It’s a complicated scenario, which I cover better in my book.

      If you do plan to try to wait it out for her and plan for PSLF for you, then you may want to take steps to minimize your monthly payments, which might be filing separately. You have to weigh the changes in your tax return vs your “savings” in monthly payments.

      She owes less than 2x her income, so honestly, I would argue you need to double down and pay hers off. The best plan is probably to file separately, you do PAYE with PSLF, and refinance her loans privately to a lower rate and pay them off as fast as possible.

      Reply
      • Ok thank you very much for this information, more help than I’ve gotten with multiple calls to loan servicer referring me back to an accountant that I don’t have. We did file jointly last April and I am due to recertify in the next month. After filing jointly, should I still pursue PAYE for lowest monthly payment do you think?

      • The servicers don’t give real advice because they’re customer service reps, not content experts, and even the advice they do give is often wrong.

        When filing jointly, it depends on if your payments cover the accruing interest. Yours probably don’t, but you need to check with the payment calculator. Assuming you’re in a negative amortization situation, one should probably pick REPAYE, because then you get an interest subsidy that reduces your effective rate (a hedge against if the PSLF thing doesn’t work out).

        That said, if you plan on filing separately next year, it’s probably best to stay in PAYE, as you often lose a month here or there as the servicers process the payment plan change and that would prolong your 120 payment count. Swapping plans twice could easily delay your eventual forgiveness by a couple months.

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