Rising rates could accelerate balance growth for income-driven student loan repayment plans


Recent increases in interest rates for new federal student loans — and the possibility of further hikes — could mean borrowers experience higher payment amounts and face greater difficulty paying off balances, depending their income and the repayment plan they choose.

The US Department of Education announcement this spring that interest rates on new loans would increase for the next academic year. Interest rates for new federal student loans are determined annually and fixed for the duration of the loan, according to a formula provided for by federal law, with a limit of 8.25% for undergraduate students. With the Federal Reserve increasing its reference rate throughout 2022 in response to inflation fears, interest rates on student loans will continue to rise accordingly.

New federal undergraduate loans now carry a 4.99% interest rate— a considerable increase compared to last year’s 3.73%. The interest rate for loans to new graduates and parents Likewise increased; it now stands at 6.28% against 5.30% the previous year. New borrowers who sign up for the standard repayment plan may see higher payments than they would have on the same balance at a lower interest rate, but these increases could create other problems for borrowers signed up for income contingent repayment (IDR) plans.

IDR plans tie monthly payments to borrowers’ income and allow outstanding balances to be written off after 240 or 300 months of qualifying payments. About 30% of all student borrowers are currently enrolled in IDR plans, which tend to have lower payments and default rates than the standard 10-year repayment plan.

A Pew analysis reveals that borrowers enrolled in IDR plans could experience accelerated balance growth, depending on whether or not their monthly payment amount covers interest accrued each month. Borrowers shouldn’t see an increase in their monthly payments, but any increase in the principal balance of their loans could further discourage borrowers who have previously reported feeling frustrated with bloated balances in their IDR plans.

Last year, in an effort to estimate the impact of a higher interest rate on IDR repayment, Pew created a “borrower example” with common characteristics, a bachelor’s degree with a estimated median income, debt and annual income increases. Referenced in a submission to the Department of Education, the median borrower with a bachelor’s degree has an annual income of $33,405 as well as a debt of $27,265 at the start of repayment and, for the purposes of this analysis, is assumed not to miss any payments. throughout the refund. Research has found that many borrowers of all types miss payments at different times. Interest can then compound during these and other repayment breaks, further accelerating balance growth.

The repayment results for this borrower at each respective interest rate indicate that new borrowers who choose to enroll in IDR will make less progress toward repayment of their principal balance than IDR borrowers who repay loans at a lower rate (see table below).

Borrowers with income-driven repayment plans face growing balances as student loan interest rates rise

Repayment results for undergraduate borrowers using old and new interest rates

Refund results Previous interest rate of 3.73% New interest rate of 4.99% 3.73% versus 4.99%
Lowest monthly payment $119 $119 No change
Highest monthly payment $194 $194 No change
Total amount paid $36,831 $36,831 No change
Director $22,184 $12,690 -$9,495
Interest $14,647 $24,141 $9,495
Remaining balance forgivable $5,606 $15,319 $9,712
Repayment period 240 240 No change

Note: The 4.99% interest rate came into effect in July 2022 and will be applied to new undergraduate loans until June 30, 2023. At that time, a new interest rate will come into effect for new loans.

Source: Pew modeling used borrower archetypes created from the longitudinal study of entry-level post-secondary students from 2004-09 and 2012-17 (BPS: 04/09 and BPS: 12/17), the 2016 American Community Survey (ACS) and the 2019 Bureau of Labor Statistics (BLS) Employment Cost Index. More information on the methodology is available at https://www.pewtrusts.org/-/media/assets/2021/11/repayment-calculator-methodology.pdf.

Due to rising interest rates, the sample borrower would have a significantly higher share of monthly payments applied to interest rather than principal. Although the regular payment amounts do not change, since the borrower’s income is the same in both scenarios, the higher interest rate means that unpaid interest accrues faster with the 4.99% rate. . This leads to nearly $10,000 more being spent on interest rather than principal over the twenty years of repayment. Each month, IDR borrowers would make less progress towards paying off their balance. The end result would be a significant increase in balance growth that could prove discouraging to borrowers’ long-term repayment efforts.

With further interest rate hikes potentially on the horizon, policymakers should consider making changes to income-focused plans to protect low- and median-income borrowers from the impact and prevalence of balance growth. Although higher interest rates would spur further balance growth, even current levels of growth have proven troublesome for some borrowers in IDR plans.

Balance growth in IDR plans is largely a result of their design – lower monthly payments and longer repayment periods cause interest to accrue when payments are less than monthly accrued interest. Despite the prospect of forgiveness after 20 or 25 years of repayment, growing balances can overwhelm borrowers and cause them to opt out of the repayment system, according to research by Pew. Opting out may result in missed payments, which could result in borrowers losing eligibility for their IDR plans or otherwise delaying forgiveness. As the ministry considers creating a new IDR plan, Pew recommends several steps to address these concerns. The government should:

  • Develop interest subsidies. In addition to subsidize unpaid interest from borrowers who make $0 payments, i.e. those whose income is below 150% of the federal poverty level guidelines—Future IDR plans should extend interest rate subsidies to payments above this amount. Extending interest rate subsidies to more borrowers, in whole or in part, would help mitigate the negative effects of growing loan balances.
  • Consider whether “gradual” surrender is administratively feasible. Recent reports have identified significant issues related to how loan servicers track eligible payments by IDR borrowers and their progress toward forgiveness, as well as how the Department of Education manages this process. The department has announcement a range of policies to address these concerns, but congressional oversight and action will be needed to ensure they are implemented in a timely manner. In addition, administrative or legislative changes to the design of the IDR plan could help prevent errors from recurring. Canceling a portion of loan balances at intervals prior to current thresholds could incentivize borrowers to continue repaying and could serve as an ongoing audit to ensure payments are counted accurately and regularly.
  • Permanent exemption of forgiven debt from income tax. As can be seen in the table above, higher rates of accumulation of unpaid interest will result in an increase in the amount of projected loan forgiveness, which has historically been treated as taxable income for borrowers. Although the US rescue plan exempts canceled balances from counting as taxable income until December 2025, a more permanent change is needed. Many borrowers who reach the forgiveness threshold have low incomes relative to their debt, which means paying the tax liability resulting from a forgiven balance could be a financial hardship. This change would require congressional action to be implemented.

A period of rising student loan interest rates should prompt policymakers to address balanced growth through evidence-based policy reforms. Income-Based Repayment Helps Many Borrowers Avoid Delinquencies and Defaults, and Federal Student Loans to offer more protections and often lower interest rates than their private counterparts. By taking steps to limit balance growth, the Department of Education can help ensure that borrowers are able to sustainably repay their loans.

Brian Denten is a leader and Lexi West is a senior associate of The Pew Charitable Trusts Student Borrower Success Project.


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