Discretionary income on student loans: What is it?

Student loans are a significant financial burden for many individuals, and understanding how discretionary income impacts repayment can be crucial for managing this debt. Discretionary income is a key factor in determining payments under income-driven repayment (IDR) plans for federal student loans. These plans are designed to make student loan payments more manageable by basing them on the borrower's income and family size.

Discretionary income is the amount of money left after paying for essential expenses such as taxes, housing, and food. It is distinct from disposable income, which is the net income remaining after taxes. Discretionary income is used for non-essential expenses like entertainment, savings, and investments.

In the context of student loans, discretionary income is calculated by subtracting a percentage of the federal poverty guideline from the borrower's adjusted gross income (AGI). This calculation varies depending on the specific income-driven repayment plan.

Income-Driven Repayment Plans

There are several types of IDR plans, each with different methods for calculating discretionary income:

Pay As You Earn (PAYE) and Income-Based Repayment (IBR) Plans: These plans calculate discretionary income as the difference between the borrower's AGI and 150% of the federal poverty guideline for their family size and state.

Income-Contingent Repayment (ICR) Plan: This plan uses 100% of the federal poverty guideline to determine discretionary income. Borrowers pay the lesser of 20% of their discretionary income or what they would pay on a fixed 12-year repayment plan.

Saving on a Valuable Education (SAVE) Plan: This plan uses 225% of the poverty guideline to calculate discretionary income, which can result in lower monthly payments compared to other plans.

How Discretionary Income Affects Loan Payments

Under IDR plans, monthly payments are typically capped at a percentage of discretionary income, ranging from 10% to 20% depending on the plan. This means that borrowers with lower discretionary incomes may have significantly reduced payments, potentially as low as $0 per month.

For example, if a borrower's annual income is $35,000 and they have a family size of three, their discretionary income under the PAYE plan would be calculated by subtracting 150% of the poverty guideline ($32,580) from their income, resulting in $2,420. If the plan requires payments of 10% of discretionary income, the monthly payment would be approximately $20.17.

Strategies for Managing Discretionary Income

To effectively manage student loan payments, borrowers can adopt several strategies:

Choose the Right IDR Plan: Selecting the most suitable IDR plan can significantly impact monthly payments and the total amount paid over the life of the loan. Borrowers should consider their income, family size, and long-term financial goals when choosing a plan.

Budgeting: Implementing a budgeting strategy, such as the 50/30/20 rule, can help borrowers allocate their income effectively. This rule suggests spending 50% of income on needs, 30% on wants, and 20% on savings or debt repayment.

Lowering AGI: Borrowers can reduce their AGI by contributing to retirement accounts like a 401(k) or a Health Savings Account (HSA). This can lower their discretionary income and, consequently, their student loan payments.

Understanding discretionary income and its role in student loan repayment is essential for borrowers seeking to manage their debt effectively. By choosing the right repayment plan and adopting sound financial strategies, borrowers can reduce their monthly payments and work towards financial stability.