Interest growth on student loan debt will slow if this new federal rule takes effect

A proposed federal rule change announced earlier this month would limit the number of ways interest is added to the principal balance — known as compounding. The change could come into effect as soon as next summer after a formal review process.
Federal student loans would still bear interest at a fixed rate set annually by law. This decision would also not lead to debt cancellation. But the change could prevent some student loan balances from skyrocketing, which can happen even when a borrower makes regular payments.

“It affects just about everyone,” said Betsy Mayotte, president of the Institute of Student Loan Counselors, a nonprofit that offers free student loan advice to borrowers.

Throughout the pandemic, most federal student loan borrowers have been spared interest accumulation thanks to the pause in payments which also froze interest. But that pandemic-related relief is set to expire after August 31.

What is interest capitalization?

When unpaid interest is added to the principal (the amount lent on which interest is paid), this is called interest capitalization. Typically, this happens whenever a loan moves from a non-repayment status to a payment status, Mayotte said.

Once compounded, future interest accrues on a larger amount, which increases the overall cost of the loan and sometimes the amount of the monthly payment.

It doesn’t happen every day. Instead, unpaid interest continues to grow separately until an event occurs that triggers compounding.

Currently, there are several times when compounding is triggered. For example, this occurs when a borrower enters repayment after completing school or at the end of a deferment or forbearance period when payments have been temporarily deferred.

Here is a simplified example. A hypothetical student loan of $10,000 earns $1 a day in interest. After 30 days, there is a principal balance of $10,000 and an interest balance of $30 per day. The next day, a compounding event occurs. If no payment is made, the principal balance is now $10,030 and interest now accrues over $1 per day, at an amount based on the interest rate and the new principal.

What would Biden’s proposal do?

Rule changes proposed by the Biden administration would limit when compounding would occur. In some cases, capitalization is required by law and cannot be changed by the administration. An example is the end of a borrower’s deferment period.

The new proposal aims to prevent the capitalization of interest where it is not required by law. The changes would only apply to direct federal loans. The interest capitalization of the federal family education loan program, which ended in 2010, would remain the same.

Under the proposed rule, interest would no longer be capitalized at these times:

  • When a borrower with an unsubsidized direct loan goes into repayment for the first time, usually six months after graduating or otherwise leaving school. (Unlike a subsidized loan, an unsubsidized loan is a loan where the government does not pay interest while the borrower is in school.)
  • When a borrower comes out of forbearance, a period of time where payments are not needed often because a borrower is experiencing financial hardship and is requesting relief.
  • When a borrower defaults on a loan, which occurs when they fail to make a scheduled payment for at least 270 days.
  • When a borrower leaves or fails to annually update their income for certain income-oriented repayment plans, including Pay As You Earn (PAYE) and Revised Pay As You Earn (REPAYE) plans.

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