Biden to limit ways that interest can inflate student loan costs

Ever wonder how someone could borrow $20,000 for college but end up owing more?

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

The Biden administration wants to spare some borrowers from this pricey feature of federal student loans.

This week, it unveiled a proposed regulation to no longer capitalize interest in certain situations, including when borrowers enter repayment or default on their loans.

“We want to ensure that student loans are more affordable,” Undersecretary of Education James Kvaal said on a call with reporters Wednesday. “Ending [interest capitalization] wherever possible will ensure that borrowers don’t see their balances balloon for reasons that seem arbitrary and illogical.”

The reform, which is expected to be implemented next July, could benefit millions of people with federal student loans. But policy experts are divided on whether it will save them much money.

“It’s not a game changer for borrowers,” said Jason D. Delisle, a senior policy fellow in the Center on Education Data and Policy at the Urban Institute. “It’s sort of like can we make this program ever so slightly 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 someone with a $30,000 loan at 4% interest. Say the loan accrues $2,000 in interest while the borrower temporarily postpones payment through forbearance. If the loan is repaid over the standard 10 years, Delisle estimates monthly payments would be $321 without capitalization and $324 with capitalization.

Yet some borrowers frequently rely on forbearance when their payments are unaffordable and may remain in postponement for several years. And for people who start 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 Advisors, said eliminating interest capitalization in most circumstances “could spell significant savings over the life of the loan, especially for people that spend a lot of time in forbearance.”

Mayotte said some borrowers she advises prefer to temporarily pause payments than to enroll in repayment plans tied to their income. Those income-driven repayment plans can offer lower monthly student loan bills, but not for everyone.

The consequences of capitalization are evident in Education Department survey data that shows 27% of people who started college in 2003-04 had a larger principal balance after 12 years than what they originally borrowed.

Black borrowers and those from low-income households were overrepresented in that group, according to the department.

The data does not break down the exact reasons for the capitalization. But the department notes that nearly 80% of Black borrowers surveyed had a forbearance at some point. The same was true for 64% of Native Americans and 59% of Latinos, compared to half of White borrowers surveyed, the department found.

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

“We know that historical disinvestment in institutions that a majority of students of color attend often forces them to take out more debt,” Itzkowitz said. “This [proposal] will help us better ensure that they are able to repay their loans more manageably.”

Student loan payments are first applied to any fees on a 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 accrues every day. That’s not going to change with the proposed rule.

For people in traditional repayment plans, their monthly outlay covers all the interest that accrues between payments. Over time, the balance and interest these borrowers pay declines.

However, people enrolled in an income-driven plan can see their balances grow when their monthly payment is less than the amount of interest accruing between bills, leading to capitalization. Although these borrowers will have the outstanding balance on their loans forgiven after 20 or 25 years of payments, experts say there is a psychological impact to throwing money at a debt that just continues to grow. Mayotte said some may feel scammed when they learn none of their payments are going to the principal.

Borrower misunderstanding of how interest accrual and capitalization work is behind the most frequent type of complaint the Education Department receives, according to the agency. In focus groups with struggling borrowers, the department found many fail to realize which decisions result in capitalization.

The proposed regulation would eliminate the added expense in most circumstances, but there are limitations.

It would not apply to people who exit deferment on certain types of federal loans, specifically Direct Unsubsidized, PLUS or Direct Unsubsidized Consolidation loans. Nor would it cover people who leave an older plan known as income-based repayment. In those cases, capitalization is required by the Higher Education Act. In other words, Congress would have to intervene to make changes.

Furthermore, the proposed rules only apply to education loans made directly by the federal government, not those that originated through the now-defunct Federal Family Education Loan Program. The rule also would not retroactively apply to past interest capitalization.

The proposal would result in a loss in revenue and increase costs for the government and taxpayers, according to the department. Yet the Biden administration anticipates the reform will lower total payments over time for borrowers, increasing the chances of them repaying their debt in full.