Agreement reached to limit certain uncontrollable balance increases

Negotiators working with the US Department of Education have reached an initial consensus on reforms to federal student loan interest capitalization. Here’s what that 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 accrued interest for that month, plus a portion of the principal. This way, with each monthly payment, the debt is paid off (even if it happens slowly) – all the interest is paid off and part of the principal is also paid off. It also means that less interest accrues each successive month; Since interest is charged as a percentage of the principal balance, as that balance decreases, the corresponding interest charges also decrease.

But for federal student loans, interest is not necessarily covered every month. During most nonpayment periods — 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 accrued interest each month. Thus, a borrower’s balance can increase over time, not decrease.

Accrued interest is bad enough for borrowers in terms of ever-increasing balances. But certain events under federal law can trigger the “capitalization” of that interest, which adds all that accrued interest to the principal balance. Then, interest continues to accrue on this now larger principal balance. Since interest is charged as a percentage of the principal balance, compounding interest can have a cumulative effect, causing the balance to grow much faster. Accrued interest may be capitalized in a variety of situations under federal law, such as a borrower entering repayment, exiting an income-driven repayment plan, failing to recertify income on time, or exiting forbearance.

Consensus reached to reduce interest capitalization events on student loans

The Biden administration has acknowledged the problems associated with capitalizing student loan interest, as it can lead to more extreme balance growth. “When compounding occurs, borrowers see balances grow faster as interest accrues on interest,” the Department of Education said in a statement accompanying the proposed changes. “Capitalization of interest is not common practice in other consumer financial products.”

The Department held negotiated rulemaking sessions to review proposals to reform key aspects of the federal student loan system, including the issue of capitalization of student loan interest. Developing negotiated rules is a lengthy, formalized process in which a committee of key stakeholders (which in this case includes student borrowers, advocates, and government and school officials) must hold public meetings to discuss proposed changes. The committee should try to reach a consensus to finalize any proposed reform.

This week, the negotiated regulatory committee reached consensus to eliminate several key student loan interest capitalization events, including the following:

  • Enter repayment after a grace period (which is the period, usually six months, immediately after a borrower graduates or withdraws from their program of study);
  • Get out of an abstention;
  • Leaving the Pay As You Earn (PAYE) or Revised Pay As You Earn (REPAYE) plan, or failing to certify income on time;
  • Default input;
  • Annual compounding of interest associated specifically with the income contingent repayment plan (ICR).

Importantly, the proposed changes do not eliminate all interest capitalization events. In particular, interest compounding may still occur in some cases for the Income Based Reimbursement (IBR) plan, as 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 affect overall interest rates for federal student loans, or prevent interest from accruing. The changes relate only specifically to capitalization.

Next steps

Changes to student loan interest capitalization will not be immediate. The negotiated regulatory committee reached consensus, which is a crucial step, but it will take another one to two years for the regulations to be updated and finalized and the changes to be fully effective.

The negotiated regulatory committee is not just working on student loan interest issues. The committee also reached consensus this week on significant changes to a student loan forgiveness program for borrowers with disabilities and is working to establish a new income-driven repayment plan.

Further Reading on Student Loans

New Student Loan Income-Based Payment Plan Details: Some New Benefits, But Proponents Are Disappointed

Department of Education Signals Big Changes to Student Loan Forgiveness Program for Borrowers with Disabilities

Student Loan Forgiveness Changes: Who Qualifies and How to Apply Under Biden’s Relief Expansion

First wave of borrowers get $715 million in student loan forgiveness under new expansion program

Bernadine J. Perkins