Rate hike could accelerate equilibrium growth for income-based student loan repayment plans – The Pew Charitable Trusts | Vette Leader

Recent increases in interest rates on new federal student loans — and the possibility of more increases — could result in borrowers facing larger payment amounts and greater difficulty repaying balances, depending on their income and the repayment schedule they choose.

The US Department of Education announced this spring that interest rates on new loans for the next academic year would rise. Interest rates on new federal student loans are determined annually and fixed for the life of the loan using a formula established by federal law, with a limit of 8.25% for students. As the Federal Reserve raises interest rates throughout 2022 in response to inflation concerns, student loan rates will continue to rise accordingly.

New federal student loans now carry an interest rate of 4.99% – a significant increase from last year’s 3.73%. The interest rate on new graduate and parent loans has also increased; it is now 6.28% compared to 5.30% in the previous year. New borrowers who sign up for the standard repayment schedule may see higher payments than they would on the same balance at a lower interest rate, but these increases could create other problems for borrowers who signed up for income-linked repayment (IDR) plans.

The IDR plans tie monthly payments to borrowers’ income and allow for the forgiveness of unpaid balances 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 lower default rates than the standard 10-year repayment plan.

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

To gauge the impact of a higher interest rate on IDR repayments, Pew last year created a “sample borrower” with common characteristics, a bachelor’s degree with estimated median income, debt, and annual income increases. A submission to the Department of Education notes that the average borrower with a bachelor’s degree has $33,405 in annual income and $27,265 in debt at the start of repayment and, for the purposes of this analysis, assumes no missed payments during the period total repayment. Research has shown that many borrowers of all types miss payments at different times. Interest can then be capitalized during this and other repayment pauses, further accelerating balance growth.

The repayment results for this borrower at the respective interest rates show that new borrowers who sign up for IDR will make less progress towards paying off their principal balance than IDR borrowers who are repaying loans at a lower interest rate (see table below).

Borrowers with income-based repayment plans face growing balances with rising student loan interest rates

Repayment results for undergraduate borrowers using past and new interest rates

Redemption Results Previous interest rate of 3.73% New interest rate of 4.99% 3.73% vs. 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
rector $22,184 $12,690 -$9,495
interest $14,647 $24,141 $9,495
Remaining Forgivable Balance $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 is valid until June 30, 2023 for new student loans. From this point in time, a new interest rate applies to new loans.

Source: Pew modeling used borrower archetypes obtained from the 2004-09 and 2012-17 Longitudinal Study Beginning Postsecondary Students (BPS:04/09 and BPS:12/17), the 2016 American Community Survey (ACS) and the Bureau of 2019 Labor Statistics (BLS) Employment Cost Index. For more information on the methodology, see https://www.pewtrusts.org/-/media/assets/2021/11/repayment-calculator-methodology.pdf.

Because of the interest rate hike, the example borrower would apply a significantly higher proportion of monthly payments to interest rather than principal. Although the regular payout amounts do not change because the borrower’s income is the same in both scenarios, the higher interest rate means that with the 4.99% rate, the outstanding interest accrues faster. This results in nearly $10,000 more in interest than principal over the twenty years it takes to pay back. Each month, IDR borrowers would make less progress toward paying off their balances. The end result would be a significant increase in balance growth that could prove discouraging for borrowers’ long-term repayment efforts.

With further rate hikes potentially on the horizon, policymakers should consider changes to income plans to protect low- and middle-income borrowers from the impact and spread of balance growth. Although higher interest rates would encourage additional balance growth, even current growth levels have proven problematic for some borrowers in IDR plans.

Balance growth in IDR plans is largely the result of their design – lowering monthly payments and lengthening repayment periods result in interest accruing 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 pull out of the repayment system, according to the Pew-led study. Withdrawal can result in missed payments, which could result in borrowers losing eligibility for their IDR plans or otherwise delaying forgiveness. As the department considers creating a new IDR plan, Pew recommends several steps to address these concerns. The government should:

  • increase interest payments. In addition to subsidizing the unpaid interest of borrowers making payments of $0 – those with incomes below 150% of federal poverty line guidelines – future IDR plans should extend interest subsidies to payments above that amount. Extending interest rate subsidies to more borrowers—in whole or in part—would help mitigate the negative impact of skyrocketing loan balances.
  • Investigate whether “incremental” forgiveness is administratively feasible. Recent reports have identified significant issues related to how credit servicers track qualifying payments from IDR borrowers and their progress toward enactment — and how the Department of Education manages this process. The Department has announced a series of policies to address these concerns, but Congressional oversight and action will be required to ensure they are implemented in a timely manner. Additionally, administrative or legislative changes to the design of the IDR plan could help prevent mistakes from repeating themselves. Forgoing a portion of loan balances at intervals ahead of current thresholds could encourage borrowers to stick with repaying and could serve as an ongoing check to ensure payments are being accurately and regularly counted.
  • Permanently exempt debt forgiven from taxation as income. As can be seen in the table above, higher interest rates result in an increase in expected loan forgiveness, which has historically been treated as taxable income for borrowers. Although the US bailout exempts waived assets from counting as taxable income until December 2025, a more permanent change is needed. Many borrowers who meet the forgiveness threshold have low incomes relative to their debt, which means that paying the tax liability resulting from a forgiven balance could represent financial hardship. This change would require action by Congress to be implemented.

A period of rising student loan rates should spur policymakers to address equilibrium growth through evidence-based policy reforms. Income-related repayment helps many borrowers avoid defaults and delinquencies, and government student loans offer more protection and often lower interest rates than their private counterparts. By taking measures to limit the growth in balances, the Ministry of Education can help ensure that borrowers can repay their loans on a sustainable basis.

Brian Denten is an officer and Lexi West is a key contributor to The Pew Charitable Trusts’ Student Borrower Success Project.

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