Policymakers Should Consider 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 paused interest accrual on all federally held student loans until Sept. 30. Although this suspension will provide temporary relief to those facing financial stress, millions of Americans see their student loan balances grow month over month.

For some, this happens even as they make regular payments, often because they are enrolled in income-driven repayment (IDR) plans—plans designed to be more affordable for many because borrowers’ monthly payments are based on their income and family size. In these cases, debt rises when monthly payments don’t keep up with the accruing interest.

Others experience balance growth when they use tools to pause payments—such as deferments and forbearances—that are intended to provide short-term relief or during periods when they are not making payments on their loans. Although IDR plans can result in the forgiveness of remaining balances after 20 or 25 years of qualifying payments, in these instances, policies intended to give borrowers’ greater flexibility at times of financial insecurity can result in balance growth that makes long-term repayment success more difficult to achieve.

To better understand how balance growth occurs and the effect it has on borrowers’ ability to repay their loans, policymakers should begin with an examination of how interest accrues and capitalizes—is added to principal—on student debt.

The impact of interest accrual and capitalization on debt

Rates of balance growth during repayment have increased over the past two decades, contributing to a decrease in the share of borrowers that pay down any of their principal within the first five years of entering repayment. Many borrowers—of all balance sizes—feel this financial burden acutely.

Rising balances primarily occur because of interest accrual and capitalization, which increases the amount subject to future interest charges. In general, interest accrues daily on federal student loans. When borrowers enter repayment, federal rules and guidance require that their monthly payments first go to unpaid interest and then to outstanding principal until the loan is paid off. Federal student loan interest rates are set each year and are fixed for the life of the loan.

The U.S. Department of Education originates 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 for undergraduate students with demonstrated financial need.
• Unsubsidized loans. Available for undergraduate, graduate, and professional students independent of need.
• PLUS loans. Available to graduate or professional students and parents of dependent undergraduate students to help pay for education expenses not covered by other financial aid.

Subsidized loans do not accrue interest if the borrower is enrolled in school at least half-time, during the six-month grace period after leaving school, and during periods of deferment. Unsubsidized and PLUS loans, however, continue to accrue interest during these times. Interest also generally accrues during periods of forbearance. And unlike most types of debt, federal student loans continue to accrue interest during default.

If eligible, borrowers can enroll in IDR plans that lower monthly payments and extend the repayment period, but this will increase the interest accrued and the amount repaid over the life of the loan. In some IDR plans, the government may pay all or a portion of the accrued interest due each month for a specified period.  

Overall, accrued interest increased at a higher average annual rate between fiscal years 2015 and 2019 than did outstanding principal, according to the Education Department.

Unpaid accrued interest can capitalize and increase principal balances

Interest capitalization, meanwhile, can occur at multiple points, including:

• After the grace period. When borrowers enter repayment after the six-month grace period, all unpaid interest is added to their outstanding balances.
• After deferments and forbearances. Any accrued, unpaid interest at the end of one or a series of consecutive deferments or forbearances—including any unpaid interest accrued prior to the start of that period—is added to the principal once the deferment or forbearance has concluded.
• Income-driven repayment. All unpaid interest capitalizes when borrowers change, exit, or become ineligible for reduced payments under an IDR plan.
• Consolidation and default. Unpaid interest also capitalizes when borrowers consolidate or default on their loans. For certain borrowers, unpaid interest also capitalizes when exiting default.

The way interest accrues and capitalizes on student loans is complex and can be difficult for borrowers to understand. The Education Department’s Federal Student Aid Ombudsman reported last year that interest accrual and capitalization leads to borrower confusion and complaints, and often requires Federal Student Aid to provide people with clarifying information. In fiscal 2019 alone, the government capitalized $21.7 billion in unpaid interest on outstanding student loans.

Balance growth caused by interest accrual and capitalization can create other barriers to repayment. A forthcoming look at responses in focus groups with borrowers conducted by The Pew Charitable Trusts indicates that growing balances lead to both financial and psychological challenges to successful repayment. Borrowers reported being overwhelmed, with many expressing frustration and diminished motivation to make payments toward balances that continue to grow.

Even before the current emergency, lawmakers from both parties had expressed willingness to help borrowers manage growing balances through capping interest accrual or eliminating capitalization. In addition, the federal government and some nonprofit organizations have proposed steps to modify the structure of IDR plans in ways that would lead to faster repayment among some borrowers, thus limiting interest accrual.

As these discussions continue, and as borrowers will again have to make regular payments on their loans, policymakers should focus on maintaining flexibility, how interest accrual and capitalization affect repayment decisions, and reducing repayment complexity. The structural changes that emerge from those discussions should address borrowers’ balance growth, help meet the needs of those struggling most with delinquency and default, and effectively use taxpayer dollars.

Sarah Sattelmeyer directs, and Brian Denten is a senior associate on Pew’s project on student borrower success.