Biden administration to limit capitalization of interest on student loans

Have you ever wondered how someone can 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 their repayment schedules, or after periods when payment has been postponed through deferral 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 this expensive feature of federal student loans. This week it presented a regulation proposal to stop capitalizing interest in certain situations, including when borrowers repay their loans or default.

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“We want to make sure that student loans become more affordable,” Secretary of State for Education James Kvaal told reporters on Wednesday. “End [interest capitalization] Wherever possible, it is ensured that borrowers do not inflate their balances for reasons that appear arbitrary and illogical.”

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

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

To get his point across, Delisle gives the example of someone with a $30,000 loan at 4 percent interest. Suppose the loan accrues $2,000 in interest while the borrower temporarily defers payment through forbearance. If the loan is repaid over the usual 10 years, Delisle estimates monthly payments at $321 without capitalization and $324 with capitalization.

However, some borrowers often rely on forbearance when their payments are unaffordable and may remain deferred for several years. And for people starting out with large amounts of debt, going for a year or two of forbearance 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 that in most cases, getting rid of interest capitalization “could mean significant savings over the life of the loan, especially for people who spend a lot of time on forbearance.”

Mayotte said some borrowers she advises prefer to temporarily pause payments sign up for repayment plans tied to their income. These income-based repayment plans can offer lower monthly student loan bills, but not for everyone.

The consequences of capitalization are evident in the Ministry of Education survey data This shows that 27 percent of people entering college in 2003-04 had more capital assets 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 dates do do not break down the precise reasons for capitalization. but The department notes that nearly 80 percent of black borrowers surveyed had some leniency at some point. The same was true for 64 percent of Native Americans and 59 percent of Latinos, compared to half of the white borrowers surveyed, the department found.

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Michael Itzkowitz, a senior fellow at centre-left think tank Third Way, said borrowers of color could struggle with their indebtedness due to economic discrimination and lack of financial resources, often leading them to borrow larger amounts than other groups.

“We know that historical divestments in institutions that a majority of black students attend often force them to take on more debt,” Itzkowitz said. “This [proposal] will help us better ensure they can repay their loans in a more manageable way.”

Student loan payments count first against any fees in a borrower’s account, then against interest, and finally against the principal balance. Unlike mortgages or credit cards, interest on federal student loans or loans adds up accrues daily. This will not change with the proposed regulation.

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

However, people enrolled in an income-based plan can see their balance grow when their monthly payment is less than the amount of interest accrued between bills, leading to capitalization. Although these borrowers will have the balance of their loans forgiven after 20 or 25 years of payment, experts say there are psychological implications of throwing money at a debt that just keeps growing. Mayotte said some may feel cheated if they learn none of their payments go to the principal.

Borrowers misunderstanding of how Accrual of Interest and Capitalization Work is the most common type of complaint received by the Department of Education, according to the agency. In focus groups with struggling borrowers, the department found that many fail to recognize the decisions leading to capitalization.

The proposed regulation would eliminate the additional costs in most cases, but there are limitations.

It would not apply to individuals ending forbearance on certain types of federal loans, specifically direct unsubsidized, PLUS or direct unsubsidized consolidation loans. It also wouldn’t cover people leaving an older plan, known as income-related payback. In these cases, the capitalization is prescribed by the Higher Education Act. In other words, Congress would have to step in to make changes.

Additionally, the proposed rules apply only to education loans directly issued by the federal government, not those originating from the now-defunct Federal Family Education Loan Program. The rule would also not apply retrospectively to past interest capitalizations.

The proposal would result in lost revenue and higher costs for the government and taxpayers, the ministry said. However, the Biden administration expects the reform will lower overall payments for borrowers over time and increase the chances that they will pay off their debts in full.

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