I’ve been going back and forth in my head between PAYE and a home equity loan through my parents, and it is turning out to be a very difficult decision to make.
As many have already mentioned, as long as you have “partial financial hardship” (which means that the standard 10-year repayment plan payments are more than 10% of your adjusted gross income minus 150% of the poverty guidelines), you will accrue “simple interest” and not “compound interest.” This basically means that your interest will not capitalize (become part of the principal balance), which in turn means that interest will not accrue on your interest, but rather on just your principal balance. Also, even if for some reason principal does capitalize, the amount that ever capitalizes over the life of the loan cannot exceed 10% of the original balance.
The scary thing is that if you are going to school at anything near sticker and taking out federal loans, it will take quite some time to pay your principal down with “brute force” even if you land big law because of the 6.8% / 7.9% interest rates, which will be adding around $20,000 to your balance each year. If you go the federal loans route, you almost have to hope that something will be done about the tax bomb because it will be extremely difficult to swim upstream against these kinds of interest rates if you land anything outside of biglaw.
Also, Papi and I have kind of been talking about this privately, but what I am worried about with PAYE is that the tax bomb will strike 20 years from now when most of us are in our mid-40s or 50s. If you are only making minimal payments (10% of your income minus the poverty guidelines), chances are that negative amortization (which means that accruing interest is greater than the payments you’re making towards the loan) will be occurring on your loans for the better part of 20 years. This could easily leave you with a $500,000+ balance at that time, which would require you to make a $200,000+ lump-sum payment that year in taxes. Although the government will only tax your forgiveness to the extent that it is less than or equal to the value of all of your assets, if you've stayed in the legal industry for that many years and have a decent pension plan, chances are that you could be taxed at the full price of the amount forgiven.
Having said that, I really think that everyone who uses PAYE will have to decide between one of two paths:
1) Start paying off your federal loans as soon as possible after graduation to keep them from growing
2) Stick with the minimum PAYE payments and prepare for the tax bomb while hoping that it will go away; don’t expect to pay off your loans with “brute force” after a couple years of minimal payments because the amount will reach a “critical mass” which will likely be very difficult to make a dent in because of the high interest rates
I am still not 100% comfortable with option #2, but it seems like the only viable thing to do if you’re set on using PAYE; if I were going with option #1, I would use a different type of loan (home equity, etc.) with lower interest rates that would actually give me a fighting chance to pay back my loans at a reasonable pace.