The Department of Education in July proposed regulations to eliminate most instances of interest capitalization for federal student loan holders with direct loans from the government. The changes represent an important step to slow balance growth and create a fairer repayment system for borrowers by addressing interest capitalization.
The Pew Charitable Trusts has flagged significant interest growth as a repayment barrier for many borrowers, backed the department’s general approach in a comment letter to the department, and urged additional steps to help borrowers stay on track as they repay their loans.
Interest capitalization—which occurs when unpaid interest is added to the principal loan balance—is often among the reasons why, as of 2012, nearly 6 in 10 student loan borrowers owed more on their loans after two years in repayment than they did when they left school. In a 2021 Pew survey, about 4 in 10 borrowers who started repayment before February 2020 said they owed more at that point than what they originally borrowed.
Capitalization can occur at several points in repayment, including at the end of the grace period—the first six months of repayment after exiting school when payments aren’t yet due. It also can happen after deferments or forbearances, when borrowers enroll in or exit an income-driven repayment (IDR) plan, when borrowers consolidate their loans, or when they default. In fiscal year 2019 alone, $22 billion in unpaid interest was capitalized and added to borrowers’ balances, according to Department of Education data.
Interest capitalization is just one cause of balance growth, but it can particularly affect borrowers who use IDR, deferments, forbearances, or who default because of an inability to make payments under the standard 10-year repayment plan.
Focus groups conducted by Pew with student loan borrowers nationwide found that many acutely feel the negative effects of interest capitalization and balance growth, even after years in repayment. Rising balances can discourage them from engaging in repayment if they perceive a lack of progress even when making on-time payments. Participants have been assigned names here to maintain their anonymity.
Taylor, a student loan borrower from Miami, saw loan balances “multiplying like loaves and fishes,” and as a result felt that “no matter how hard I try, I’m never going to get to the end of it.”
Similar sentiments were echoed by others. Jordan, a student loan borrower from Detroit, said: “When I last looked at the number, it was almost twice what I owed when I first left law school 18 years ago. … I’ll be collecting Social Security and my student loans will finally get paid off.”
For Sam, a borrower from Portland, Maine, growing balances were so discouraging that they felt that going by the “statistical human life span, I will die before they are paid off.” Focus groups held by other research groups have reported similar themes from student loan borrowers.
Although the elimination of many capitalization events in the department’s proposal would help address one component of the balance growth experienced by borrowers, such growth will continue for those enrolled in IDR plans whose monthly payments do not cover accrued interest, especially as interest rates rise. IDR plans calculate monthly payments based on a borrower’s income and family size and typically offer lower monthly payments than the standard 10-year repayment plan.
Borrowers enrolled in IDR plans meet the criteria for loan forgiveness of remaining balances after 20 or 25 years of qualifying payments, but balance growth still leads borrowers to feel significant distress. According to Pew estimates, many low-income borrowers would have most or all of their original balances forgiven under current IDR plans if enrolled, which raises questions about whether the psychological burdens created by balance growth are justified considering the lack of recaptured loan revenue in some cases.
Pew’s project on student borrower success has proposed several principles for reform of the student loan repayment system to reduce balance growth broadly, some already addressed in the Education Department proposal. The federal government should:
- Expand interest subsidies. Providing more subsidies to more borrowers—in full or in part—would help address the negative effects of mushrooming loan balances. The Department of Education has released a proposal for a new IDR plan that includes an expanded interest subsidy that would cover all unpaid interest as long as borrowers make their required monthly IDR payments. This full interest subsidy could help IDR borrowers in the new plan largely avoid the negative psychological and financial impact of balance growth.
- Enhance payment tracking. The Government Accountability Office (GAO) recently identified significant problems with the process used to count qualifying payments. Accurate numbers are essential to verify eligibility for loan forgiveness under the current suite of IDR plans. Proposals to accelerate the amount of time until low-income borrowers receive forgiveness should be considered to potentially address the psychological burdens of long-term balance growth and ensure that the resources of loan servicers are more efficiently allocated over time.
- Additionally, the department could explore whether incremental forgiveness is administratively feasible. Regularly forgiving a portion of borrowers’ balances at shorter intervals, perhaps as an incentive for making a certain number of payments, could help maintain their engagement with the repayment system and provide policymakers and stakeholders with a fuller picture of the repayment status of the federal student loan portfolio. It also could act as an ongoing audit to ensure that servicers are accurately counting borrowers’ qualifying payments.
- Continue to implement the Fostering Undergraduate Talent by Unlocking Resources for Education (FUTURE) Act. The department can take steps beyond the regulatory process to help borrowers be more successful in repayment. Although the department’s proposed rule would eliminate interest capitalization associated with exiting most IDR plans, the annual recertification process that borrowers needed to remain enrolled in these plans can still cause other problems for them. These can include temporary enrollment in the standard repayment plan, under which they may face unaffordable payments.
If codified, the proposed changes to interest capitalization would decrease balance growth for many student loan borrowers, especially those most likely to encounter challenges affording payments. The department has already taken positive steps to eliminate interest capitalization where it has the authority to do so. Such steps are an integral part of a larger effort to improve the student loan repayment system by making repayment simpler and more affordable for the 43 million Americans who hold federal student loans.
Brian Denten and Spencer Orenstein are officers and Lexi West is a principal associate with Pew’s project for student borrower success.