The story at a glance
- The Ministry of Education has proposed to eliminate certain cases of capitalization of interest on student loans held by the federal government.
- This is a lesser-known mechanism where interest accrues and adds to the principal balance of a loan, compounding the amount a borrower ends up paying over the life of the loan.
- Currently, unpaid interest accrues each year during any period of negative amortization, which is when a borrower does not make payments high enough to cover accrued interest or the principal balance.
A new rule proposed by the Department of Education could transform the way student loan interest is capitalized, potentially saving borrowers thousands of dollars.
Interest compounding is a lesser-known student loan mechanism that occurs when a loan, while in a grace period such as a deferral or income-driven repayment plan, continues to accumulate interest which is then added to the principal balance.
The result is that the interest rate on the loan is applied to an ever-increasing principal balance, which the ministry wants to change.
It is proposed to eliminate compounding when a borrower goes into repayment, exits forbearance, defaults on a student loan, or exits most income-oriented repayment plans, saying it “will help borrowers who have struggling to repay their loans.
However, the proposed rule states that there will always be instances in which capitalization of interest may occur, as required by the Higher Education Act.
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Offering limits will help borrowers, as student loan debt in the United States currently stands at around $1.7 trillion, while the average federal student loan debt balance is $37,014.
Lawmakers are pushing for further reforms. Sen. Sheldon Whitehouse (DR.I.) on Monday proposed a bill that would allow student debt holders to refinance their loans at zero percent interest.
“Big interest payments on student loans can create a treadmill of debt that many Americans cannot escape. These interest payments often stand between borrowers and the financial freedom to focus on the future, whether that means buying a home, saving for retirement, or investing in their children,” Whitehouse said in a statement.
Currently, the Department of Education annually capitalizes unpaid interest during any period of negative amortization, i.e. when a borrower does not make payments high enough to cover accrued interest or the principal balance. .
Negative amortization can occur in a few cases, including when a borrower is on Income Oriented Repayments (IDR) – which allows borrowers to have dramatically low monthly payments, even down to $0. However, while in IDR payments are often too low to cover the cost of accrued interest which keeps rising despite regular payments, leading experts want further reform.
According to an analysis by the Brookings Institute, about one in three student borrowers whose loan comes directly from the federal government, known as direct loan borrowers, are enrolled in some form of IDR.
“Removing capitalization is necessary but not sufficient. Negative amortization and interest capitalization work in concert, so we need to tackle both,” said Sarah Sattelmeyer, Project Director for Education, Opportunity and Mobility in the Higher Education Initiative of New America, at Changing America.
Interest capitalization can also occur while a borrower is in a grace period where they are not required to make monthly loan payments, known as deferment or forbearance. Due to the COVID-19 pandemic, nearly all federal student loan borrowers are in forbearance, and the department has applied a 0% interest rate.
Regardless of the circumstances, if a borrower enters a grace period or IDR, the Federal Student Aid handbook states that interest can accrue annually at 5%.
It’s a problematic process that Sattelmeyer described as leading to frustration, with borrowers feeling demoralized and ending up paying more money over time.
A January poll found that 62% of American adults with federal student loans said their debt was negatively affecting their mental health — and 81% said they had to delay key life milestones, like save for retirement or buy a house to pay off their student loans.
“We’ve kind of already established that if somebody’s got a really low income, they’re making these low payments, and so I think to really manage balanced growth, you have to address both, not just one or the other. ‘other.”
The proposed changes will be subject to public comment over a 30-day period once published in the Federal Register. After that, the federal government will respond to comments and release the final rules this fall that would go into effect July 1, 2023.
Posted on July 13, 2022