Episode Transcript
Brenton: [00:00:00] In September of this year, federal student Loan borrowers will see interest accrue on their Debt for the first time in over three years. In this episode, we tell you how federal student Loan interest works, how it compares to other forms of Debt, and how knowledge of these facts can help you in your student Loan journey.
Let's get started.
Brenton: Hello, my name is Brenton Harrison of Escape Student Loan Debt, and your host for the Escape Student Loan Debt podcast. Hope you guys had a good July 4th. I hope that you weren't too discouraged by the news that the Department of Education will no longer be able to offer the 10 or $20,000 of forgiveness.
And in the last episode that we covered where I talked about the details of that decision, I told you that in the following episode we'd talk about federal student Loan interest because the way federal student Loan interest works as compared to other forms of Debt is really unique. [00:01:00] But the other reason is because there were a couple of references to student Loan interest when it came to the press releases and the announcements that the Biden administration made following the decision to strike down that forgiveness program.
The first reference to federal student Loan interest, which is kind of buried in the details of these announcements, but it lets you know that there's somewhat of an importance when it comes to the topic, was when they were discussing the SAVE plan.
We've covered in the previous episodes, the updated version of Revised Pay As You Earn. The Department of Education decided to just go ahead and give it its own new acronym, so it's now called the SAVE plan. It's the saving on a valuable education plan. And when giving the details of that plan and the final regulations, there's a reference to interest capitalization, which is a topic we'll cover in this episode.
And it says that as of July 1st, interest capitalization, when you exit many of the Income Driven Repayment plans, not all of them, will cease. So again, we'll cover what interest capitalization [00:02:00] means shortly. We'll also cover which of the plans will no longer see interest capitalized when you see an exit from those plans as well.
And the second reference to student Loan interest came for people who are unable to make payments when they start again in October. I'm quoting from the Federal Student Aid website. It says, for borrowers who still cannot make their payments, the US Department of Education is creating a temporary on-ramp period over the next year that will help borrowers avoid the harshest consequences of missed partial or late payments.
During that time, missed partial or late payments will not lead to negative credit reporting default, or loans being sent to collection agencies. Borrowers who can make payments should do so as payments will be due and interest will accrue during this on-ramp period. Additionally, missed payments will not count towards Loan forgiveness under any of the income during Repayment plans or public service Loan forgiveness.
So probably in another episode we'll cover what all of that meant. But the part I [00:03:00] want you to key on for this episode is the fact that even if you don't make payments during this 12 month on ramp period, interest will still accrue.
So now that you know that it's important, how does interest work on a federal student Loan as compared to Debt, like a mortgage or any other form of investment? And to explain that concept of the difference between the two, I have to explain the difference between simple interest and compound interest.
Compound interest is interest growing on top of interest, and it's really powerful when it's working for you. I'll give you an example. Let's say that you have a hundred dollars and that a hundred dollars is going to grow at a rate of 10% compound interest each year. Well, the first year you take your a hundred dollars, you multiply it and you find that 10% of a hundred dollars is $10. So $10 of interest is growing on your a hundred dollars. At the end of the year you have $110 left. Well, the start of year two, you have [00:04:00] $110 in total, and it is growing at 10% compound interest, and that means that when you calculate the interest for this year, you don't calculate 10% of the original a hundred dollars. You calculate 10% of $110, and that means that in year two as opposed to $10 of interest growing on your investment, you now have $11 of interest that's growing on your investment. 10% of your original total plus the added interest from the previous year. Compound interest is interest growing on top of previously accrued interest.
And compound interest is extremely powerful. Let's take it to bigger numbers, and let's say that you have a hundred thousand dollars that's growing at a rate of 10%. Well, that first year you get $10,000 growing on top of a hundred thousand, and then next year you get $11,000 growing on top of $110,000.
If you go even bigger and you have $300,000, you go from $30,000 of interest in the first year at a rate of [00:05:00] 10% to $33,000 of interest in the next year because it's growing on top of that previously accruing interest. And you can get to the point when it comes to compound interest, where when it's working for you, you can have more growing in interest than you're even able to save on your own accord.
It is really, really powerful. Now, it is just as powerful when it's working against you. If you think about it, if you're not paying enough to cover the interest on a hundred thousand dollars Loan, that's growing at 10% interest. Then the next year, if it's compounding, you're having to pay 10% on not just the original a hundred thousand that you owe, but that a hundred thousand plus whatever interest you did not cover in the previous year.
Now, why is this important? It's important cuz many federal student Loan borrowers utilize Income Driven Repayment plans to pay their federal student loans.
And as we've said many times, these plans do not necessarily make you pay enough to actually pay down the Debt. And in many cases, not only [00:06:00] will it not pay down the Debt, it won't even cover the growing interest. So that means that even though you are technically making a payment, the amount of total Debt that you owe on your loans is increasing in spite of that payment
And if federal student Loan interest compounded, you would see people who already owe hundreds of thousands of dollars get to the point where they owe millions of dollars in federal student loans.
Because that compound interest becomes a runaway train where you can't pay enough to cover it, and that next year, even more interest grows than the year before.
Thankfully, federal student Loan interest does not compound. Federal student Loan interest is simple interest, and here's the difference as compared to compound where interest grows on top of previously accrued interest. Simple interest says that whatever the interest rate is on your Debt, it will always be calculated based off of the original total.
So in our example where we have a hundred thousand dollars growing at a rate of 10% interest with [00:07:00] simple interest, in the first year, you have $10,000 of interest, 10% of the a hundred thousand dollars Loan. But with federal student loans, instead of adding that on top of the original balance, they put it in a separate category.
This is why when you look at your federal student Loan statements, you see two numbers. You see one number that says the Loan principle balance, and you see a separate number that says the interest. It is because the Department of Education separates the interest that's growing from the actual corpus of your Loan, which means that in year two, in our example, when 10% interest accrues, it's not on $110,000. It's on your original a hundred thousand dollars.
Now, I know you're saying, Hey, that's still $10,000. That's a lot of money, but trust me, over the course of five or 10 or 15 years, that subtle difference between simple interest and compound interest can make a tremendous difference when it comes to what your actual student Loan balance is after that period of time.[00:08:00]
And when it comes to having student loans forgiven under things like the public service Loan forgiveness, it's not a big deal cuz there's no taxes when student loans are forgiven. When it comes to even how Income, Driven Repayment plan forgiveness is operating right now, it's not a big deal because right now there are no taxes due on the forgiveness that comes from Income Driven Repayment plans.
We've also mentioned that in the year 2025, that's due to expire at the end of the year and beginning in 2026, they will go back to the old rules. And those old rules says that when you have federal student loans for forgiven under Income, Driven, Repayment plans, it is taxable as income to you in the year of forgiveness.
So even when it comes to what you could have to pay in taxes by having your loans wiped away, simple interest can help manage and limit the amount of federal student loans that you have forgiven as compared to compounding, which could have disastrous results if any forgiven loans are taxable to you as income.
Now that you understand how federal student Loan [00:09:00] interest works after the break, we'll tell you what it means for it to capitalize.
We'll cover how the SAVE plan has changed interest when it comes to not just that plan, but other Income Driven Repayment plans and what to know in advance of interest resuming on your Debt in September of this year.
[00:10:00]
Brenton: Before the break, we made a reference to interest capitalization. So let's cover what that means when it comes to your federal student loans.
You now know when it comes to how your Debt is structured for federal student loans, that when you look at your statement, you'll see a category that says Loan principle balance in a separate category where the interest goes so that it's not adding on top of that original Loan balance.
What happens when your interest capitalizes is they take that separate interest category and they add that balance onto your original Loan principle, and moving forward, in our example, instead of having 10% growing on a hundred thousand dollars, if there were $30,000 of interest in that separate category, They would add it onto the Loan principle, and now 10% will be growing on $130,000. And as a result, you would have more interest [00:11:00] growing every single year.
So interest capitalization is a big no-no. It's something you want to avoid if at all possible.
Now there are several things that can happen to cause the interest on your federal student loans to capitalize.
One of those things is when you come out of deferment on an unsubsidized Loan. You'll recall that a subsidized Loan is when the interest that's accruing on your Loan is covered by the federal government.
So when you have deferment on a subsidized Loan, you don't have to worry about any capitalization because that Debt is covered by someone else. In this case, the federal government, an unsubsidized Loan is a Loan where interest accrues and there's no one there to cover it. It's up to you. So when you've had a period of deferment on an unsubsidized Loan, when you exit deferment and go back into Repayment, that interest will automatically capitalize and be added onto your principal balance.
Now another major event that would lead to interest capitalization prior to the introduction of the SAVE plan was when you would exit an Income Driven Repayment plan. Now you might exit [00:12:00] because you're no longer eligible because of your income, you could Earn too much and you could bump up against that cap as we've covered, you could forget to recertify your income and that would be a reason under the REPAYE plan that they would cause the interest to capitalize onto the Loan balance.
You may just decide to switch from an Income Driven Repayment plan to a standard plan and whenever that would occur, you would see an immediate capitalization of the unpaid interest onto your principle, that would be really devastating. With the introduction of the SAVE plan, they are sharing that you no longer have to worry about that for any plan except the income based Repayment plan.
So if you're on the Pay As You Earn plan, or if you're on the SAVE plan, we've covered that the PAYE plan is kind of getting phased out, if you leave that plan for any reason, you no longer have to worry about interest capitalizing onto your balance.
The only people on these plans who have to worry are those who are on income-based Repayment, who choose to leave income-based Repayment for any reason.
So that's the way interest [00:13:00] capitalization works for direct loans or FFEL loans that are managed by the Department of Education. But remember, there are FFEL loans that are not managed by the education department. And for those, there are more instances where that capitalization can occur.
With the federal student government loans that are managed by the education department, they have done away with interest capitalization when you come out of forbearance.
But for those loans that they don't manage, they can't take care of that. So if you have an FFEL Loan that's managed by an entity other than the education department, you go into forbearance when you come out, your interest rate capitalizes. Yet another reason why if you have an FFEL Loan, in my opinion, the safest thing to do is to just consolidate it into a direct consolidation Loan for these loans that are FFEL and not managed by the education department.
You will also see interest rate capitalization when you finish your grace period on an unsubsidized Loan. Most of the time when you graduate, you have a six month grace period following graduation. If you're leaving grad school [00:14:00] and you have unsubsidized loans that are not managed by the Department of Education, if you come out of that grace period, your interest will capitalize.
And lastly, if you have FFEL loans that are not managed by the education department, uh, and you're paying them under income based Repayment, and you leave the plan for any reason, you will also see interest capitalized.
Now we've covered a lot and I wanted this episode to really just be the foundation of interest so that we can, in the next episode, talk about how it impacts the decision of whether you should keep your federal student loans with the federal government, or whether you should refinance them with a private lender.
So in the next step, now that you know how federal student Loan interest works, we're going to talk about how that impacts your decision of whether the federal government is still the right place to keep your student loans.
See you then.
[00:15:00]
