Biden administration to limit interest capitalization on student loans

Have you ever wondered how someone could borrow $20,000 for college but end up owing more?

Enter the interest capitalization. This is when unpaid interest is added to the principal of a loan. This can happen when someone changes repayment plans or after periods of payment deferral or forbearance. This increases the total amount owed and forces borrowers to pay interest on the higher balance, driving up the overall cost of the loan.

The Biden administration wants to spare some borrowers that costly feature of federal student loans. This week, it unveiled proposed regulations to no longer capitalize interest in certain situations, including when borrowers go into repayment or default on their loans.

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“We want to make sure student loans are more affordable,” Education Undersecretary James Kvaal said on a call with reporters on Wednesday. “End [interest capitalization] where possible, ensure that borrowers do not see their balances inflate for reasons that seem arbitrary and illogical.

The reform, which is expected to be implemented next July, could benefit millions of people on federal student loans. But political pundits are divided on whether it will save them a lot of money.

“It’s not a game-changer for borrowers,” said Jason D. Delisle, senior policy researcher at the Center for Education Data and Policy at the Urban Institute. “It’s kind of like we can make this program a little fairer and give people a better chance of feeling like they’re making progress on their debts.”

To make his point, Delisle gives the example of a person with a $30,000 loan at 4% interest. Suppose the loan earns $2,000 in interest while the borrower temporarily defers payment by forbearance. If the loan is paid off over the standard 10 years, Delisle estimates the monthly payments would be $321 unfunded and $324 funded.

Yet some borrowers frequently rely on forbearance when their payments are unaffordable and may remain deferred for several years. And for people starting out with high debt balances, using forbearance for a year or two can be expensive. In those scenarios, Delisle said the proposed reform would carry more weight.

Betsy Mayotte, president of the nonprofit Institute of Student Loan Counselors, said eliminating interest capitalization in most cases “could result in significant savings over the life of the loan, especially for people who spend a lot of time abstaining”.

Mayotte said some borrowers it advises prefer to temporarily suspend payments than to enroll in income-related repayment plans. These income-driven repayment plans may offer lower monthly student loan bills, but not for everyone.

The consequences of capitalization are evident in the education department survey data This shows that 27% of people who started college in 2003-04 had a larger principal balance after 12 years than they originally borrowed. Black borrowers and those from low-income households were overrepresented in this group, according to the department.

The data do not break down the exact reasons for capitalization. But the department notes that nearly 80% of black borrowers surveyed have been forbearing at some point. The same is true for 64% of Native Americans and 59% of Latinos, compared to half of white borrowers surveyed, the department found.

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Michael Itzkowitz, senior fellow at the center-left think tank Third Way, said borrowers of color can struggling with their debt due to economic discrimination and a lack of financial resources that often lead them to borrow higher amounts than other groups.

“We know that historic divestment in institutions attended by the majority of students of color often forces them to take on more debt,” Itzkowitz said. “This [proposal] will help us better ensure that they are able to repay their loans in a more manageable way. »

Student loan payments are applied first to fees on the borrower’s account, then to interest, and finally to the principal balance. Unlike mortgages or credit cards, interest on federal student loans adds up or accumulates every day. This will not change with the proposed rule.

For people on traditional repayment plans, their monthly expenses cover all accrued interest between payments. Over time, the balance and the interest these borrowers pay decrease.

However, those enrolled in an income-oriented plan may see their balance increase when their monthly payment is less than the amount of interest accrued between bills, resulting in compounding. Although these borrowers will see their outstanding loan balances forgiven after 20 or 25 years of payments, experts say there is a psychological impact to throwing money at debt that continues to grow. Mayotte said some might feel ripped off when they learn that none of their payments are going to the principal.

Misunderstanding of the borrower How? ‘Or’ What accrued interest and capitalization work is the most frequent type of complaint received by the education department, depending on the agency. In focus groups with distressed borrowers, the ministry found that many do not realize which decisions result in capitalization.

The proposed settlement would eliminate the extra expense in most cases, but there are limits.

This would not apply to people coming out of the deferment of certain types of federal loans, especially direct unsubsidized, PLUS or direct unsubsidized consolidation loans. It also wouldn’t cover people who leave a former scheme known as income-contingent reimbursement. In these cases, capitalization is required by law on higher education. In other words, Congress should step in to make changes.

In addition, the proposed rules apply only to student loans made directly by the federal government, not to those created through the now defunct federal family student loan program. Nor would the rule apply retroactively to past capitalization of interest.

The proposal would result in lost revenue and increase costs for the government and taxpayers, according to the ministry. Still, the Biden administration predicts that the reform will reduce total payments over time for borrowers, increasing the chances that they will repay their debt in full.

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