Negotiators working with the U.S. Department of Education have reached an initial consensus on reforms to federal student loan interest capitalization. Here’s what it means for borrowers.
What Is Student Loan Interest Capitalization?
Under a normal repayment schedule for most types of consumer debt, a borrower’s monthly payment would cover all of the interest that had accrued for that month, plus some of the principal. That way, with each monthly payment, the debt is being paid down (even if it’s happening slowly) — all interest is repaid, and a bit of principal is repaid, as well. This also means that less interest accrues in each successive month; since interest is charged as a percentage of the principal balance, as that principal balance goes down, so do the corresponding interest charges.
But for federal student loans, interest may not necessarily be covered each month. During most periods of nonpayment — such as deferment, forbearance, and grace periods — interest typically accrues on most types of federal student loans. And for borrowers in an income-driven repayment plan (where monthly payments are based on a person’s income, not their loan balance), a normal monthly payment may not even be high enough to cover all of the accruing interest each month. So a borrower’s balance may go up over time, not down.
The accruing interest is bad enough for borrowers in terms of an ever-growing balance. But certain events under federal law can trigger “capitalization” of that interest, which adds all of that accrued interest back on to the principal balance. Then, interest continues to accrue on that now-larger principal balance. Since interest is charged as a percentage of the principal balance, interest capitalization can have a compounding effect, leading to much more rapid balance growth. Accrued interest can capitalize in a variety of situations under federal law, such as a borrower entering repayment, leaving an income-driven repayment plan, failing to re-certify their income on time, or exiting a forbearance.
Consensus Reached To Reduce Student Loan Interest Capitalization Events
The Biden administration has acknowledged the problems associated with student loan interest capitalization, as it can lead to more extreme balance growth. “When capitalization occurs, borrowers see balances rise faster as interest accrues on interest,” said the Department of Education in a statement accompanying proposed changes. “Interest capitalization is not a common practice across other consumer financial products.”
The Department has been holding negotiated rulemaking sessions to review proposals to reform key aspects of the federal student loan system, including the issue of student loan interest capitalization. Negotiated rulemaking is a lengthy, formalized procedure where a committee of key stakeholders (which in this case includes student loan borrowers, advocates, and representatives from government and schools) must hold public meetings to discuss proposed changes. The committee must try to reach consensus to finalize any proposed reforms.
This week, the negotiated rulemaking committee reached a consensus to eliminate several key student loan interest capitalization events, including the following:
- Entering repayment following a grace period (which is the time period, usually six months, immediately following a borrower’s graduation or withdrawal from their degree program);
- Exiting a forbearance;
- Leaving the Pay As You Earn (PAYE) or Revised Pay As You Earn (REPAYE) plan, or failing to certify income on time;
- Entering default;
- Annual interest capitalization associated specifically with the Income Contingent Repayment (ICR) plan.
Importantly, the proposed changes do not eliminate all interest capitalization events. In particular, interest capitalization may still occur in certain instances for the Income Based Repayment (IBR) plan, because most changes to the IBR plan would have to be made by Congress due to the way the IBR program was initially established. The changes also do not effect overall interest rates for federal student loans, nor do they stop interest from accruing. The changes only specifically pertain to capitalization.
Next Steps
The changes to student loan interest capitalization won’t be immediate. The negotiated rulemaking committee reached a consensus, which is a critical step, but it will still take another one to two years for the regulations to be updated and finalized and for the changes to be in full effect.
The negotiated rulemaking committee isn’t only working on student loan interest issues. The committee also reached consensus this week on significant changes to a student loan forgiveness program for disabled borrowers, and is working on establishing a new income-driven repayment plan.
Further Student Loan Reading
Education Department Signals Big Changes To Student Loan Forgiveness Program For Disabled Borrowers
Student Loan Forgiveness Changes: Who Qualifies, And How To Apply Under Biden’s Expansion Of Relief
First Wave Of Borrowers Gets $715 Million In Student Loan Forgiveness Under New Program Expansion
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