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Student loan debt-relief plan isn’t for everybody

If you're a student-loan-burdened recent college graduate putting the final touches on a note to President Obama, thanking him for his recent executive order on debt repayment, don't get too excited.

Obama formally widened the pool of eligible participants in the Pay As You Earn (PAYE) program and said that it could save recent graduates hundreds of dollars every month, helping an additional 5 million people manage their student debt.

The revised program caps monthly loan payments at 10 percent of discretionary income, which is defined as income exceeding 150 percent of the federal poverty level.

The federal government also uses loan forgiveness as an incentive to encourage recent college graduates to pursue full-time government or nonprofit work. The Public Service Loan Forgiveness program will forgive the debt of students after 10 years if they enter broadly defined "public service" jobs, mitigating the burden of debt for graduates pursuing fields not known for being lucrative.

That certainly helps, but it isn't going to help a majority of college graduates.

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PAYE tends to save money only for those low-income borrowers who have incurred an unusually large federal debt — so much debt that the government agrees to forgive whatever isn't paid off after 20 years.

Attention is often focused on extreme cases of students who borrowed hundreds of thousands of dollars. But only 3.7 percent of borrowers — including graduate students and parents who borrow to pay for their child's education — actually take on debt in six figures.

Let's look at the hypothetical case of a college graduate earning $46,900 as a graphic designer who will have an annual income increase of 5 percent.

She has borrowed $100,000 and is charged 6.8 percent interest. According to the federal Repayment Estimator calculator, if the graphic designer meets her payments each month for 20 years — at 10 percent of her discretionary income plus interest, her payments would start at $245 in her first month of repayment and reach $717 by her last — the federal government will forgive nearly $130,000 of her remaining debt plus interest accrued over time.

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In total, she will pay $106,581.

Now consider an alternative payment route. If the graphic designer paid off her debt using the federal government's 10-year Standard Repayment Plan, under which payments hold at a fixed amount each month for up to 10 years, she would pay a much greater sum each month, over a much shorter period of time.

Repaying her debt within the 10-year limit demands monthly payments of $1,151. Including interest, and without the big benefit of a debt forgiveness stipulation, the graphic designer pays nearly $30,000 more than she would have using PAYE, according to the repayment calculator.

But there's a catch. The relief of PAYE's debt forgiveness can come with an onerous tax liability. Because the graphic designer did not choose a profession that qualifies for the Public Service Loan Forgiveness program, the "forgiven" debt could qualify as taxable income.

In a more common case, the graphic designer would have a debt of $29,400, the median federal student debt for a bachelor's degree. Now she would actually save close to $3,000 overall by paying a flat rate from the time she graduates until she has whittled down the debt.

If we think of a hypothetical roommate for the graphic designer — a Wall Street investment banker — PAYE also doesn't work as well. The banker's larger income requires larger monthly payments, and she is more likely to pay off a six-figure debt before getting to the 20-year debt forgiveness.

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If the banker earns a salary of $85,300 (plus a hefty signing bonus), and repays her loans at 10 percent of her monthly income, under PAYE she will pay off her full $100,000 of debt, plus interest, in 14 years and nine months. The banker saves $30,000 by paying down her debt using the standard plan's flat rate: $1,151 every month for 10 years.

PAYE's real impact can come from the financial relief it provides during the first unsteady months after graduation, when job security and steady income are less stable. In this respect, PAYE does what it was designed to do: act as a stopgap.

It can accommodate the unpredictability of life, offering young borrowers limited flexibility to repay their debt at a rate that leaves enough left over to pay rent each month.