Rate Hike Could Speed Balance Growth for Income-Driven Student … – The Pew Charitable Trusts

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Recent increases in the interest rates for new federal student loans—and the possibility of additional hikes—could result in borrowers experiencing higher payment amounts and facing greater difficulties in paying down balances, depending on their income and the repayment plan they choose.
The U.S. Department of Education announced this spring that interest rates for new loans would increase for the next academic year. Interest rates for new federal student loans are determined annually and fixed for the life of the loan, using a formula stipulated by federal law, with a limit of 8.25% for undergraduates. With the Federal Reserve increasing its benchmark rate throughout 2022 in response to inflation concerns, student loan interest rates will continue to rise accordingly.
New federal undergraduate loans now carry a 4.99% interest rate—a sizable increase over last year’s 3.73%. The interest rate for new graduate and parent loans similarly has risen; it now stands at 6.28% over the previous year’s 5.30%. New borrowers who enroll in 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 enrolled in income-driven repayment (IDR) plans.
The IDR plans tie monthly payments to borrowers’ income and allow unpaid balances to be forgiven after 240 or 300 months of qualifying payments. About 30% of all student loan 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 finds that borrowers enrolled in IDR plans could experience accelerated balance growth, depending on whether their monthly payment amount covers the interest that accrues each month. Borrowers should not see increases in their monthly payments, but any increase in the principal balance of their loans could further discourage borrowers who have previously reported feeling frustrated about ballooning balances in their IDR plans.
Last year, in an effort to estimate the impact of a higher interest rate on IDR repayment, Pew created an “example borrower” with common characteristics a bachelor’s degree with estimated median income, debt, and annual increases in income. Referenced in a submission to the Department of Education, the median borrower with a bachelor’s degree has an annual income of $33,405 along with $27,265 in debt at the start of repayment, and, for the purposes of this analysis, is assumed to not miss any payments throughout repayment. Research has found that many borrowers of all types miss payments at different points. Interest then can capitalize during these and other repayment disruptions, further accelerating balance growth.
The repayment outcomes for this borrower at each respective interest rate indicate that new borrowers who choose to enroll in IDR will make less progress toward paying down their principal balance than IDR borrowers repaying loans with a lower rate (see table below).
Repayment outcomes for undergraduate borrowers using previous and new interest rates
Note: The 4.99% interest rate went into effect in July 2022 and will be applied to new undergraduate loans until June 30, 2023. At that point, a new interest rate will go into effect for new loans.
Source: Pew modeling used borrower archetypes created from the 2004-09 and 2012-17 Beginning Postsecondary Students (BPS:04/09 and BPS:12/17) Longitudinal Study, the 2016 American Community Survey (ACS), and the 2019 Bureau of Labor Statistics (BLS) Employment Cost Index. More information on methodology is available at https://www.pewtrusts.org/-/media/assets/2021/11/repayment-calculator-methodology.pdf.
Because of the interest rate hike, the example borrower would have a significantly higher share of monthly payments applied to interest rather than principal. Although the regular payment amounts do not change, as the borrower’s income is the same in both scenarios, the higher interest rate means that unpaid interest accrues more quickly with the 4.99% rate. That leads to nearly $10,000 more going toward interest rather than principal over the twenty years they spend in repayment. Each month, IDR borrowers would make less progress toward paying down their balance. The end result would be a significant increase in balance growth that could prove discouraging to borrowers’ long-term repayment efforts.
With more interest rate hikes potentially on the horizon, policymakers should consider making changes to income-driven plans to protect low- and median-income borrowers from the impact and prevalence of balance growth. Although higher interest rates would spur additional balance growth, even current levels of growth have proven troublesome for some borrowers in IDR plans.
Balance growth in IDR plans is largely the result of their design—lowering monthly payments and extending repayment periods cause interest to accrue when payments are less than the monthly accrued interest. Despite the prospect of forgiveness after 20 or 25 years of repayment, growing balances can overwhelm borrowers and cause them to disengage from the repayment system, according to research done by Pew. Disengagement can lead to missed payments, which could result in borrowers losing eligibility for their IDR plans or otherwise delaying forgiveness. As the department considers creation of a new IDR plan, Pew recommends several steps to address these concerns. The government should:
A period of rising student loan interest rates should spur policymakers to address balance growth through evidence-based policy reforms. Income-driven repayment helps many borrowers avoid delinquency and default, and federal student loans offer more protections and, often, lower interest rates than their private counterparts. By taking action to limit balance growth, the Department of Education can help ensure that borrowers are able to sustainably pay down their loans.
Brian Denten is an officer and Lexi West is a principal associate with The Pew Charitable Trusts’ project on student borrower success.
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A new federal proposal to help Americans repay their student loans would make repayments more affordable for many borrowers but should be improved to better benefit those most at risk of delinquency and default. That’s what The Pew Charitable Trusts found when it modeled scenarios of how the proposed Expanded Income-Contingent Repayment (EICR) plan would affect repayments compared with an existing plan, the Revised Pay As You Earn (REPAYE) program. Both the proposed and existing programs are income-driven repayment plans, which tie monthly payments to the borrower’s income.
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.
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