Policy makers should consider the impact of growing student loan balances on borrowers and taxpayers

To help families maintain financial stability during the coronavirus pandemic, the federal government recently suspended payments and suspended interest accruals on all federally held student loans through September 30. Although this suspension will provide temporary relief to those in dire financial straits, millions of Americans are seeing their student loan balances grow month by month.

For some, this happens even during regular payments, often because they participate in income-driven repayment (IDR) plans – plans that are more affordable for many because borrowers make monthly payments based on their income and family size. In these cases, debt increases if monthly payments don’t keep pace with accruing interest.

Others experience balance growth when using means of payment such as deferrals and deferrals designed to provide short-term relief, or during times when they fail to pay their loans. Although IDR plans can result in remaining balance waived after 20 or 25 years of qualifying payments, in these cases guidelines designed to give borrowers more flexibility in times of financial uncertainty can result in balance growth that increases long-term repayment success, which is difficult to achieve reach.

To better understand how equilibrium growth comes about and how it affects borrowers’ ability to repay their loans, policymakers should begin by examining how interest accrues and capitalizes – added to capital – on student debt.

The effects of accrued interest and capitalization on debt

Have balance growth rates during repayment elevated in the past two decades contributed to a to decrease Proportion of borrowers who repay part of their capital within the first five years after repayment has occurred. Many borrower– of all balance sizes – feel this financial burden acutely.

Rising balances arise mainly from interest accruals and capitalization, which increases the amount of future interest charges. Generally there is interest Daily on federal student loans. When borrowers make a repayment, federal rules and regulations require that their monthly payments be made up of unpaid interest first and then outstanding principal until the loan is repaid. The interest rates on federal student loans are set every year and are fixed for the term of the loan.

The US Department of Education makes new loans through the William D. Ford Federal Direct Loan Program, commonly known as “Direct Loans.” Borrowers and their families can take out three types of these loans:

  • Subsidized Loans. Available to undergraduate students with proven financial need.
  • Unsubsidized loans. Available to students, graduates and professionals regardless of need.
  • PLUS loan. Available to college graduates or working students and parents of dependent students to pay for training costs not covered by other financial aid.

Funded loans do not earn interest if the borrower starts school at least halfway through the six-month grace period after leaving school and during the deferred periods. However, interest on unsubsidized and PLUS loans continues to be paid during these times. As a rule, interest also accrues during the deferral periods. And unlike most types of debt, federal student loans continue to accrue interest during the default.

If eligible, borrowers can sign up for IDR plans that decrease monthly payments and extend the repayment period, but this increases the interest accrued and the amount repaid over the life of the loan. Some IDR plans allow the government to pay all or part of the accrued interest each month for a period of time.

Overall, the accrued interest increased by a higher Average annual rate between 2015 and 2019 fiscal years as the outstanding school principal, according to the Ministry of Education.

Unpaid accrued interest can activate and increase principal balances

Interest capitalization, meanwhile, can be done at several points including:

  • After the grace period. When borrowers repay after the six month grace period, any unpaid interest is added to their outstanding balances.
  • After reprieve and forbearance. Any accrued unpaid interest at the end of one or more consecutive deferrals or deferrals – including any unpaid interest accrued prior to the start of that period – will be added to principal once the deferral or deferral is complete.
  • Income-based repayment. All unpaid interest is capitalized when borrowers switch, exit, or are not eligible for reduced payments under an IDR plan.
  • Consolidation and Standard. Unpaid interest is also capitalized when borrowers consolidate their loans or default. For certain borrowers, unpaid interest is also capitalized when exiting the default.

The way that interest on student loans is accrued and capitalized is complex and may be difficult for borrowers to understand. The Ministry of Education’s Ombudsman for Student Aid reported Over the past year, this accrued interest and capitalization has created confusion and complaints from borrowers and often required federal student aid to provide clarifying information to people. The government capitalized in the 2019 financial year alone $ 21.7 billion unpaid interest on outstanding student loans.

Net growth through accrued interest and capitalization can create other repayment obstacles. An upcoming look at the responses in focus groups with borrowers conducted by The Pew Charitable Trusts shows that growing balances create both financial and psychological challenges for a successful repayment. Borrowers said they were overwhelmed, with many expressing frustration and decreased motivation to make payments for growing balances.

Even before the current emergency, the legislators of both parties had agreed to allow borrowers to manage growing assets caps Accrued interest or eliminate Capitalization. In addition, the federal government government and some non-profit Organizations have proposed steps to change the structure of IDR plans to result in faster repayment for some borrowers, thereby limiting interest rate exposure.

As these discussions continue and borrowers have to return to making regular payments on their loans, policy makers should focus on maintaining flexibility in how accrued interest and capitalization affect repayment decisions and reduce repayment complexity. The structural changes emerging from these discussions should address equilibrium growth of borrowers, help meet the needs of those most struggling with delinquency and defaults, and use taxpayers money effectively.

Sarah Sattelmeyer is directing and Brian Denten is a senior associate at Pew’s Student Loan Success Project.

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