Eliminating Interest Capitalization on Student Loans is a Win for Borrowers

February 7, 2022 by John Huston

In the fall of 2021, the U.S. Department of Education (“Department”) began the rulemaking process to amend federal student loan regulations to eliminate interest capitalization events for student loan borrowers.[1] Under current Department regulations, when students enter repayment on their student loans, the accrued interest is added to the principal balance of the loan in what is called “interest capitalization.”[2] After interest capitalization occurs, loans accrue interest on the original principal balance plus any capitalized interest.[3] There are several other scenarios where regulations require interest to be capitalized, which the Department is also proposing to eliminate.[4]

Although interest capitalization rarely grabs headlines in the news media, it can be very costly for students.[5] For example, take a law student who borrows the maximum Direct Unsubsidized Loans for Graduate and Professional Students of $20,500 per year for each of the three years the student is in school, with even disbursements at the beginning of the Fall and Spring semesters. The current interest rate for such loans is 5.28%, so the borrower will accrue $7,306 in interest over the three years and during the six-month post-graduation grace period in which the borrower is not expected to make loan payments. If this interest is capitalized, or added to the principal balance, the borrower would pay an extra $17.62 per month and an $2,114 extra in interest over the life of the loan.[7]

All student loan borrowers have an interest capitalization event after they leave school and enter repayment. In addition, borrowers who enter forbearance, default, or switch repayment plans can also have their loans capitalized.[9] This can be particularly expensive for students who stay in school for an extended period to earn multiple successive degrees or for borrowers that spend extended amounts of time in forbearance because of financial hardship.[10]

Interest capitalization is relatively unique to student loans.[11] With most other types of consumer loans, like auto loans and mortgages, interest capitalization is not possible for borrowers who make payments on-time because their payments must at least cover accrued interest to avoid having the loan negatively amortize. Student loans, on the other hand, do not require students to make any payments while they are in school, including on interest.[13]

The Higher Education Act of 1965 allows but does not require the Department to capitalize interest when certain “capitalization events occur.”[14] The Department’s current regulations require capitalization to occur when a borrower (1) enters repayment, (2) exits forbearance, (3) defaults on a student loan, (4) fails to recertify income on an income-driven repayment (IDR) plan; (5) switches from an IDR plan to a standard non-income based repayment plan; and (6) when significant amounts of interest accrue on an income-contingent repayment plan.[15]

In December of 2021, the Department came to consensus during negotiated rulemaking  to eliminate these regulations that require capitalization.[16] The Department will now use the regulatory language that was agreed upon during negotiated rulemaking to develop a notice of proposed rulemaking (NPRM).[17] After taking public comment on the NPRM, the Department will have the opportunity to finalize those rules to help borrowers.[18] If the final rule eliminates the aforementioned capitalization events, it will help all student loan borrowers with unsubsidized Stafford and PLUS loans that have yet to enter into repayment save money because such loans accrue interest while the borrower is in school. The Higher Education Act prevents the Department from finalizing rules expeditiously, but borrowers might expect this change to take effect in late 2022.[20] This proposed change is a significant development and could be a big win for many borrowers, and especially those borrowers still in school that have unsubsidized Stafford loans or PLUS loans.

[1] U.S. Dep’t of Educ., Issue Paper #3: Interest Capitalization Session 1: October 4-8, 2021, https://www2.ed.gov/policy/highered/reg/hearulemaking/2021/3eliminateintcap.pdf (accessed Oct. 2, 2021).

[2] Id.

[3] Id.

[4] Id.

[5] Anna Helhoski, What Is Capitalized Interest on Student Loans?, NerdWallet (April 9, 2021), https://www.nerdwallet.com/article/loans/student-loans/student-loan-interest-capitalization

[6] The Direct Unsubsidized Loans for Graduate and Professional Students interest rates fluctuate based on market rates and change on July 1st of every year for new loans disbursed on or after that date. See Dep’t of Educ. Website, What is the current interest rate for Direct Subsidized and Unsubsidized Loans?, (last visited Nov. 18, 2021), https://studentaid.gov/help-center/answers/article/what-is-current-interest-rate-for-direct-unsubsidized-loans.

[7] This calculation assumes that the borrower enrolls in the standard repayment plan, which amortizes the loan evenly over 120 months, and does not miss any payments nor enter forbearance during the loan period. If the borrower enters forbearance or misses payments, the total interest cost for the loan would be higher. The standard repayment plan is the default repayment plan for all federal student loans. Additionally, this calculation assumes that the loan for each academic year is disbursed in two even $10,250 payments, with one payment at the beginning of the Fall semester and one at the Spring semester. If the loan was disbursed on a different schedule, the total interest cost may vary.

[8] U.S. Dep’t of Educ., supra note 1, at 1.

[9] Id.

[10] Id.

[11] Id.

[12] Consumer Financial Protection Bureau, What is negative amortization?, (Sept. 4, 2021), https://www.consumerfinance.gov/ask-cfpb/what-is-negative-amortization-en-103/ (Negative amortization occurs when payments do not exceed accrued interest and the loan balance grows, even though the borrower is making monthly payments).

[13] U.S. Dep’t of Educ., supra note 1, at 1.

[14] 20 U.S.C. § 1078-8(e)(2)

[15] 34 C.F.R. §§ 685.209(a)(2)(iv), 685.209(c)(2)(iv), 685.202(b)(4), 685.202(b)(3), & 685.220(f)(3)

[16] Adam Minsky, Student Loan Interest: Agreement Reached to Curtail Some Runaway Balance Increases, Forbes (Dec. 3, 2021), https://www.forbes.com/sites/adamminsky/2021/12/09/student-loan-interest-agreement-reached-to-reduce-some-runaway-balance-increases/?sh=66ba319237fb

[17] Dep’t of Educ. Website, The Negotiated Rulemaking Process for Title IV Regulations – Frequently Asked Questions, (last visited Jan. 3, 2021) (“If consensus is achieved, the Department uses that regulatory language in its NPRM”).

[18] Id.

[19] Dep’t of Educ. Website, COVID-19 Emergency Relief and Federal Student Aid, (last visited Nov. 18, 2021) (All federal Direct Loans are subject to a 0% interest holiday as part of the administrative relief provided by the Department due to the coronavirus pandemic. This interest holiday is currently scheduled to end after January 31, 2021. Eliminating interest capitalization will primarily help borrowers after the interest holiday has ended).

[20] 20 U.S.C. § 1089.