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January 26, 2015

What Triggers Student Loan Interest Capitalization?

Sometimes a student loan borrower isn’t required to make payments on his or her loans, for example:
• when he’s in school his loans and his loans are in deferment, 
• for the six months after he leaves school when his loans are in a grace period, and
• during other periods of authorized deferment or forbearance. 

But on unsubsidized loans, interest is nearly always accruing (with a few exceptions).  

So if a borrower isn’t making payments, what happens to the unpaid interest?
Specific events trigger unpaid accrued interest to be capitalized.  Capitalization is when the lender adds the interest to the principal balance of the loans.  That’s not super, because once the interest is capitalized, it becomes principal.  And what does principal do?  It generates interest.  Ugh.  Interest on federal student loans will be capitalized upon these (and other, keep reading) triggering events:
1. When the loan enters repayment.
2. When a deferment ends.
3. When forbearance ends.
4. When the loan defaults (ack!)
5. A change in repayment plan.
6. Loan consolidation. 
What goes on with capitalization when a borrower is making payments on her loans?  
It depends.  Monthly payments under some repayment plans (including standard, graduated, and extended repayment plans) are set at amounts sufficient to cover all the interest that is accruing; there won’t be any unpaid accrued interest to capitalize (assuming the borrower is making the required payments).
But if a borrower is enrolled in an income-driven repayment plan (like Income-Based Repayment and Pay As You Earn), monthly payments may not fully cover all the interest that is accruing.  That’s part of the plan, to allow smaller payments for borrowers with low incomes relative to their debt.  So what happens to that unpaid accrued interest?  For borrowers in Income-Based Repayment or Pay As You Earn, it’s capitalized upon specific triggering events:
1. If the borrower is determined to no longer have “partial financial hardship”.
2. If the borrower chooses to leave the repayment plan. 
3. If the borrower fails to submit, on time, the documentation required to renew participation in the repayment plan (income and family size verifications).
4. Under Pay As You Earn (but not Income-Based Repayment), unpaid interest is capitalized only until the outstanding principal amount is ten percent greater than the original principal amount.  After the outstanding principal amount is ten percent greater than the original amount, interest continues to accrue but is not capitalized as long as the borrower remains in Pay As You Earn.

Note that I decided not to bother describing the deal with Income-Contingent Repayment; a’int nobody got time for that.  If you have a burning desire, read the regs here: http://www.law.cornell.edu/cfr/text/34/685.209
By Heather | Category: Pay As You Earn, IBR, Student Loan Repayment  
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