New proposed rule could transform student loan interest

Story at a glance

• The Education Department has proposed eliminating certain instances of interest capitalization on federally held student loans.

• It’s a lesser-known mechanism in which interest accrues and is added to a loan’s principal balance, compounding how much a borrower ends up paying over the life of the loan.

• Currently, unpaid interest accrues annually during any period of negative amortization — which is when a borrower isn’t making payments high enough to cover accrued interest or the principal balance.

A new rule proposed by the Education Department could transform the way student loan interest is capitalized, possibly saving borrowers thousands.

Interest capitalization is a lesser-known student loan mechanism that occurs when a loan, while in a grace period such as deferment or an income-driven repayment plan, continues to accrue interest that’s then added to the principal balance.

This results in the loan’s interest rate being applied to an ever-growing principal balance, something the department wants to change.

It’s proposed eliminating capitalization when a borrower enters repayment, exits forbearance, defaults on a student loan or exits most income-driven repayment plans, saying it will “help borrowers who struggle to repay their loans.”

However, the proposed rule states there will still be instances in which interest capitalization can occur, as required within the Higher Education Act.

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Proposing limits will help borrowers, as student loan debt in the U.S. currently totals about $1.7 trillion, while the average federal student loan debt balance is $37,014.

Lawmakers are pushing for further reform. Sen. Sheldon Whitehouse (D-R.I.) on Monday proposed a bill that would make it possible for student debt holders to refinance their loans at zero percent interest.

“Big student loan interest payments can create a treadmill of debt that many Americans can’t escape. Those interest payments often stand between borrowers and the financial freedom to focus on the future, whether it’s buying a home, saving for retirement, or investing in their children,” Whitehouse said in a statement.

Currently, the Education Department capitalizes unpaid interest annually during any period of negative amortization — which is when a borrower isn’t making payments high enough to cover accrued interest or the principal balance.

Negative amortization can happen in a few instances, including while a borrower is in Income-Driven Repayments (IDRs) — which allows borrowers to have drastically low monthly payments, even down to $0. However, while in IDR, payments are often too low to cover the cost of accrued interest that keeps growing despite regular payments, leading experts wanting further reform.

About one in every three student loan borrowers whose loan comes directly from the federal government, known as Direct Loan borrowers, is enrolled in some form of IDR, according to an analysis by the Brookings Institute.

“Removing capitalization is necessary but not sufficient. Negative amortization and interest capitalization work in concert, and so we have to address both of them,” Sarah Sattelmeyer, project director for education, opportunity, and mobility in the Higher Education initiative at New America, told Changing America.

Interest capitalization can also occur while a borrower is in a grace period where they aren’t 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 percent interest rate.

Regardless of the circumstance, if a borrower enters a grace period or IDR, the Federal Student Aid handbook says interest can accrue annually at 5 percent.

It’s a problematic process that Sattelmeyer described as leading to frustration, borrowers feeling demoralized and ultimately paying more money over time.

One poll conducted in January found that 62 percent of U.S. adults with federal student loans said their debt negatively affects their mental health — and 81 percent said they’ve had to delay key life milestones, like saving for retirement or buying a home, in order to pay off their student loans.

“We’ve sort of already established that if someone has really low income, they’re making these low payments, and so I think in order to really manage balanced growth, you have to address both, not just one or the other.”

The proposed changes will be up for public comment over a 30-day period once published in the Federal Register. After that, the federal government will address comments and publish final rules this fall that would take effect July 1, 2023.

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