If you have ever been interested in Income-Driven Repayment plans, the chances are high that you came across the term- discretionary income. You might be unfamiliar with this income type or think it is the same with disposable income. However, discretionary earning is a part of income that does not include taxes or essential spendings. It is the amount you spend on fancy dinners or vacations.
But how to calculate discretionary income? How does it relate to your student loans? We answer these questions and many more in this guide.
What is Discretionary Income?
Discretionary income is the amount left after deducting taxes and living expenses – necessary costs – from the original income amount. Necessary spendings include expenses for food, accommodation, utilities, etc. In other words, discretionary income indicates the part of earning that could be used for non-essential spendings.
According to Federal Student Aid’s definition, discretionary income is the excess amount when we deduct 150% of the poverty guideline from the earned annual income level. Poverty Guideline is determined by the Department of Health and Human Services considering the family size and location of living. For example, if you live in Alaska and have two people in the family, the poverty guideline is $21,770. Meanwhile, for a family of two living in Columbia, this rate is only $17,420. Keep in mind that numbers change yearly.
Disposable vs. Discretionary Income
Sometimes, discretionary and disposable income terms are used interchangeably. However, these two terms indicate different earring types and amounts. Disposable income covers both essential and non-essential spending. It is the amount left after deducting taxes from the original earning balance.
For example, you can use disposable income to buy food (essential) or to go on vacation (non-essential). Meanwhile, discretionary earning is derived from disposable income. The amount left is discretionary when we deduct all necessary expenses (food, rent, utility expenses, transportation, etc.) from disposable income.
Why is Discretionary Income Important for Student Loans?
What matters for your student loans is discretionary income as opposed to disposable one. Discretionary earning is specifically essential for federal student loan borrowers. When such borrowers enroll in Income-Driven Repayment plans, their monthly loan payment amounts are calculated using discretionary earnings. In general, the repayment amount is either 10%, 15%, or 20% of discretionary income under these repayment plans.
Income-Driven repayment plans are based on what you earn. By considering your discretionary income, the government creates a plan in which you can allocate money for necessary living expenses and use the discretionary part of the earnings to pay out your debt. Therefore, Income-Driven repayment plans are usually more affordable for the buyer. If you earn less money, you will be required to pay only 10-20% of your discretionary revenue (after deducting essential expenses and taxes) for your debt obligations.
We will discuss Income-Driven repayment plans in detail in subsequent sections.
How is Discretionary Income Calculated?
If you want to enroll in Income-Driven repayment plans, you have to know how much you will be required to pay under these plans. Generally, loan servicers provide insights on this matter, but knowing what to expect beforehand is advisable.
For example, imagine you earn $40,000 yearly, and you live in Alaska, in a family of two. Previously, we mentioned that the poverty guideline for such a family is $21,770. 150% of this amount is:
1.$21,770 x 1.5 or $21,770 x 150/100 = $32,655
If we deduct this amount from yearly income:
2. $40,000 – $32,655 = $7,345
We are left with $7,345 yearly discretionary earnings.
Keep in mind that your discretionary income level can change. Therefore, if you enroll in Income-Driven repayment plans, you will be required to submit earning and family size information yearly so that the officials can calculate the new rate. The changes can happen if your income or family size changes. Besides, poverty guidelines are updated yearly, affecting the discretionary amount calculated during the previous year. Additionally, if you move to a place where poverty guidelines are different, the discretionary revenue level can change.
Types of Income-Driven Repayment Plans
As mentioned before, discretionary income is mainly used for calculating monthly loan payment amounts under Income-Driven Repayment plans. These plans are usually more affordable for borrowers because they pay the debt according to their earnings left for unnecessary expenses. In other words, borrowers do not touch their earnings for essential costs like food or rent expenses. Therefore, debt repayment is easier under these plans.
There exist four different types of Income-Driven Repayment plans. We will quickly introduce you to the plans, but you can check our blogs if you want to get more detailed information.
Revised Pay as You Earn
Revised Pay as You Earn is one of the repayment plans created during the Obama administration to help borrowers access the lowest rates. Hence, it is not surprising that this plan requires only 10% of the discretionary earnings. You repay the undergraduate debt for 20 years and graduate/professional degree debt for 25 years with this plan. After this period, the remaining debt is forgiven.
Pay as You Earn
Another similar repayment plan created to ease borrowers’ debt burden is Pay as You Earn. This plan also requires 10% of discretionary earnings, and its payback period is 20 years. The forgiveness rule again applies to the plan.
The conditions for an Income-Based repayment plan change depending on when you received the loan. If you are a new borrower (you did not have an open Direct or FFEL loan balance while getting a new loan) after July 2014, you pay only 10% of discretionary income monthly. In such cases, the payback period is 20 years. If you are not a new borrower, 15% of discretionary earnings is required for 25 years before the remaining debt is canceled.
Under this repayment plan, you pay monthly either 20% of discretionary income or a fixed amount to pay the debt in 12 years. The payback period is 25 years.
How is Payment Rate Calculated Using Discretionary Earning?
Let’s roughly calculate how much you will pay under an Income-Driven repayment plan using our previous scenario. Living in Alaska, in a family of two, your discretionary income is $7,345 per year. Imagine you want to enroll in a Pay as You Earn (PAYE) repayment plan, which requires 10% of your annual discretionary earnings over 12 months. In such case, 10% of your discretionary earning is:
1. $7,345 x 0.1 = $734.5
Now, we need to divide this yearly payment amount by 12 to find the monthly payment amount under the Pay as You Earn plan:
2. $734.5 / 12 = $61.2
If you are not good at math, do not worry. You do not have to calculate this rate. Instead, the Education Department provides a loan simulator on the official Student Aid website, calculating the rate.
Biden’s Approach to Income-Driven Repayment Plans
Speaking of Income-Driven repayment plan rates, it is essential to note that they might change. When Biden was running for the presidency, he shared his “Plan for Education beyond High School.” This plan suggested changes like simplifying Public Service Loan Forgiveness, increasing Pell Grants’ limits, or improving income-based plans’ generosity.
Biden suggested a repayment plan where the monthly payment amount would be only 5% of discretionary income- lower than the existing Income-Driven repayment plans. In this way, borrowers would pay 5% of discretionary earnings for 20 years, and the remaining balance after this period would be forgiven.
Additionally, Biden mentioned that he wants to change the tax code so that debt forgiven after the payback period will not be taxed. Currently, student loan forgiveness is not taxable until 2025.
Changes Might Happen Soon
The Biden administration has already started to work on its promises. To improve Income-Driven repayment plans and possibly create a new plan, the administration started reviewing the programs. This process is done through “Negotiated Rulemaking,” which brings considerable changes to regulations but does not require Congress’s approval.
Such a review process starts with public hearings. Once it is done, rules are drafted and again presented to the public for feedback.
The Obama administration also utilized “Negotiated Rulemaking” to introduce two new repayment options, called Pay as You Earn (PAYE) and Revised Pay as You Earn (REPAYE). These plans considerably decreased the amounts required for monthly payments. As explained before, currently, they require the lowest amounts- 10%, but Biden aims for even cheaper repayment with 5% of discretionary income.
Besides decreasing the monthly payment amount, the “Negotiated Rulemaking” can result in repayment programs with shorter payback periods, no taxation, or interest accrual. Additionally, the officials might start considering the volume of borrower’s expenses for determining the discretionary earning.
How to Reduce Monthly Payments?
If your current monthly payments are prohibitive, you might consider methods to lower the debt payments.
Changing Repayment Plan
Changing the repayment plan usually helps borrowers to pay less for the debt obligations. Specifically, Income-Driven repayment plans are known for their affordability. Under these plans, if you earn less income, you will have even lower discretionary earnings (as we deduct taxes and essential living expenses from annual income).
When discretionary income is low, its small percentage -10 to 20%- for the debt payments will not create many challenges for your budget.
These repayment plans are affordable because the repayment amount does not depend on how much money you owe. Rather, it depends on how much you earn, which is more suitable for your finances.
Student Loan Refinancing
Unfortunately, only federal loan borrowers qualify for Income-Driven repayment plans. Therefore, if you have private student debt, you will not be able to enjoy the lowest rates of these plans. Instead, you can refinance your debt.
Both federal and private loan borrowers can qualify for this program. However, it is not usually recommended to federal borrowers because they can qualify for more financial aid types, such as discharge or forgiveness programs. If they refinance, they will lose eligibility for federal student debt benefits.
Now let’s understand what refinancing is. Refinancing happens when you get a new refinancing loan and use the money you receive to payout/close the existing loan. You might think that such a movement of funds will not change anything. However, refinancing reduces your monthly payments if your new loan has a lower interest rate.
When is the Right Time for Refinancing?
If you can get better loan terms with refinancing loans, it is the best time. For example, you hear that loan interest rates have decreased. You do some research and find that some lenders provide the amount you need (remaining debt balance) with a lower interest rate. In this case, getting a new loan will save you money by reducing the interest amount.
However, you should be careful and be informed about all costs- including origination and other fees- to make a better decision.
Besides, some borrowers might struggle with their lenders. Lenders can be hard to communicate with, annoying, or under pressure. If you want to change lender or loan servicer, you can refinance to get rid of them.
Lastly, when you refinance, your credit score might increase. This is because as you pay out previous debt, credit performance improves.
Federal student aid programs and repayment plans usually do not require a credit check. Therefore, it is understandable that students who have no prior credit history will not pass the credit check successfully. However, private lenders perform student loan refinancing. Hence, they require a good credit score – higher than 600- to disburse a loan.
Besides, you need to have a stable income. In this way, lenders guarantee the repayment of refinancing loans. In addition, if you lack income or credit score, you can get help from co-signers. A co-signer is a family member or friend who agrees to repay the debt if you fail to meet obligations. When a co-signer exists, loan requirements can be lowered.
Think Fast, Act Fast…
If you are struggling with debt repayment, it is best to develop a new debt repayment/resolution strategy.
Due to the pandemic, the government stopped federal debt collection for more than a year. Lately, Biden extended the pause on collection till January end of 2022. This decision gives you five more months to analyze and plan your repayment once it starts.
The pandemic might affect your finances negatively. If you think your income is lower now, you can consider moving to Income-Driven Repayment plans. Do not forget that your monthly payment would be lowered if your discretionary revenue is decreased or you lost someone in the family.
Talk to your loan servicer or one of our debt experts to know your options. Our experts have helped thousands of borrowers like you to repay the debt effectively. You can schedule a free consultation now so that our debt specialists find a way out of your debt concerns. So be prepared to repay even before it knocks on your door.
Discretionary income is the amount left after deducting taxes and essential expenses like food spending or rent from your yearly income. This income type is necessary for your student loans because it determines your monthly payments under Income-Driven repayment plans.
Such plans require around 10-20% of your discretionary earnings. Therefore, if the discretionary part of your income is low, your monthly payment amount will be low as well. However, Biden currently aims to help borrowers access repayment plans where only 5% of discretionary income is needed. The government calculates your discretionary earnings by deducting 150% of poverty guidelines from your adjusted yearly income. Poverty guidelines depend on your geographical location and family size. Besides, it changes yearly. If you are not sure how much is your discretionary earning or how to calculate the repayment rate, you can use the loan simulator of ED or contact your loan servicer.