If your student loan balance over the years has seemed to magically increase despite regular, on-time payments, and you owe more than you originally borrowed, you’re not alone. It’s not magic, or a curse, even if it looks like it. It’s interest capitalization, and it’s a sneaky way to increase borrowers’ balances so you feel like you’ll never get out of your student loan debt – even if you’ve already paid more than that. that you borrowed in the first place. But now there is a plan to mitigate it.
Despite campaign promises to resolve the student loan crisis, forgive at least $10,000 of debt per borrower, and consider deeper loan forgiveness, the Biden administration has continued to reduce the crisis piece by piece. As Administrator Biden examines widespread forgiveness and forgiveness of large swaths of debt for people who were defrauded at for-profit colleges, they also examined another part of the problem that made the crisis so bad: interest. on student loans. This time, by tackling the insidious process of interest capitalization, the government plans to limit how interest can be added to the principal balance of loans – a process called interest capitalization.
What is interest capitalization?
Interest capitalization occurs when unpaid interest is added to your main balance. This usually occurs following periods of deferment (when you do not repay your loan for up to three years and may not have interest on the loan) or forbearance (when you suspend temporarily loan repayments in times of financial crisis, but the interest on the loan increases) or when you consolidate or refinance your student loans.
When you repay your loan each month, the payments are split first into the fees you owe, then the interest, then your principal balance, the amount you actually borrowed. After a forbearance, deferral, consolidation, or refinance, the amount owed in interest can be added to the principal amount, causing the principal balance to increase and borrowers paying interest on the money they don’t have. have never borrowed.
This tactic, which is unique to the student loan debt industry and not seen in other debtor industries – can you imagine this happening to your mortgage, for example? – can add thousands of dollars to balances and leave borrowers paying interest on interest for years after the original principal amount has been paid off.
The Biden administration has a plan to deal with interest capitalization. While this is helpful for future borrowers, it might not be enough for borrowers who have experienced this scheme before.
How many people have experimented with interest capitalization?
Department of Education survey data shows that 27% of people who started college in the 2003-2004 school year had balances larger than their original borrowed amount 12 years later. Another estimate from 2018 found that less than a quarter of people with student loans actually repaid their primary loan. This means that over 75% of students could simply pay off their interest and people’s debt continues to grow.
Unsurprisingly, interest capitalization hurts marginalized communities the most – black and low-income borrowers have been disproportionately affected.
The data also shows that 80% of black borrowers, 64% of Native American borrowers, and 59% of Latinx borrowers had loans that were forborne, increasing the likelihood that these borrowers would experience interest compounding.
Biden’s plan for capitalizing student loan interest
To address the growing student loan crisis, the Biden administration plans to limit the loans to which student loan interest capitalization can be applied in the future. The process will not be completely removed, but it will be removed for loans that meet certain criteria.
Capitalization will no longer occur for:
- Federal loans coming out of forbearance
- Defaulted Federal Loans
- Federal Loans Coming Out of Grace Period
- Borrowers exiting certain types of income-driven repayment plans like Pay As You Earn
Federal loans that have been suspended due to Covid-19 pandemic protections will also not be funded when repayment begins later this year.
Interest capitalization will always be an issue for unsubsidized loans from deferral, loans from former income-based repayment plans, and if required by specific laws. Also, unfortunately, the changes won’t be retroactive, meaning if you’ve already experimented with interest compounding, you’ll still have to pay back what you currently owe, even if your balance is inflated due to interest compounding.
When will the changes take place?
The plan will enter a 30-day public comment period and is expected to be finalized on November 1, 2022. The changes will take effect in July 2023. Biden administration documentation indicates that this plan will reduce overall federal revenue and increase the burden taxpayers. “Because there would be fewer situations in which interest is capitalized, this proposal would result in lost revenue and therefore increase costs to the government and therefore US taxpayers. However, the proposal is expected to result in lower total payments over time for borrowers, increasing the likelihood that borrowers will repay their loans in full. Given this benefit, the Department believes that the benefits to borrowers outweigh these costs and justify the change.