“This affects everyone,” says Betsy Mayotte, president of the Student Loan Counseling Institute, a nonprofit that provides free student loan advice to borrowers.
During the pandemic, most federal student borrowers have not accrued interest as the pause in payments also resulted in interest rates being frozen. But this pandemic-related relief will expire after August 31.
What is interest capitalization?
When unpaid interest is added to the principal (the loan amount on which interest is paid), it is called interest capitalization. Generally, this happens whenever a loan goes from default to paying, Mayotte says.
This doesn’t happen every day. Instead, unpaid interest continues to grow individually until an event occurs that triggers the capitalization.
Currently, there are a number of times when capitalization is triggered. For example, it occurs when a borrower begins to repay a loan after finishing school or at the end of a deferment or forbearance period when payments are temporarily deferred.
Here is a simple example. A hypothetical $10,000 student loan is accruing $1 in interest per day. After 30 days, there is a principal balance of $10,000 and an interest balance of $30 days. On the next day, a capitalization event occurs. If no payments are made, the principal balance is now $10,030 and the interest is now accruing more than $1 a day, with the amount based on the new interest and principal.
What would Biden’s proposal do?
The rule changes proposed by the Biden administration would limit the number of capitalizations. In some cases, capitalization is required by law and the authority cannot be changed. One example is when the borrower’s deferral period ends.
The new proposal aims to prevent interest rate capitalization when not required by regulation. The changes will only apply to federal Direct Loans. Interest capital from the Federal Family Education Loan program, ending in 2010, will remain the same.
Under the proposed rule, interest will no longer be capitalized at the following times:
- When a borrower with an unfunded Direct Loan begins repaying for the first time, usually six months after graduation or drop out of school. (Unlike a subsidized loan, an unfunded loan is one for which the government does not pay interest while the borrower is in school.)
- When a person borrows the patiencea period in which payments are not frequently requested because the borrower is in financial difficulty and requires relief.
- When a borrower default for a loan, occurs when the person fails to make scheduled payments for at least 270 days.
- When a borrower leaves or fails to annually update his or her income for some income-based repayment planincludes a Pay as You Earn (PAYE) plan and a Modified Pay As You Earn (REPAYE) plan.