New plan is game changer for student loan interest

For many student-loan borrowers, interest capitalization has been the bane of their existence. It’s why loans that might have been reasonably affordable become financially debilitating after years of deferment or forbearance.

Balances balloon when a borrower’s monthly loan payments do not cover the interest because it’s tacked onto the principal. Interest is then applied to the new, larger loan amount. This is how the debt grows over time and can make the monthly payment unmanageable.

But under a new income-driven repayment plan, Saving on a Valuable Education — SAVE, borrowers won’t see their balances grow even if their payments don’t cover the interest they owe. This could be a game changer for folks who would otherwise be trapped in loan payments for decades.

Like other income-driven repayment plans, SAVE calculates monthly payments based on a borrower’s income and family size. It is now the most affordable repayment plan, according to the Department of Education.

There are many great features of SAVE — some that were implemented this summer and others that begin July 1, 2024. But the one about interest capitalization in effect now is significant.

Here’s how interest works on a SAVE plan.

Let’s start with the amount of income protected from payments: That benchmark will increase from 150% to 225% of the federal poverty guidelines.

This means a single borrower earning $32,805 or less ($67,500 for a family of four) will not owe a loan payment. Borrowers who earn more would save more than $1,000 a year on their payments compared with other income-driven repayment plans.

You may wonder, as I did, what about the interest that isn’t being paid?

The Education Department will not charge any monthly interest not covered by the borrower’s payment. This means borrowers who pay what they owe on the SAVE plan — even if it’s zero dollars every month — will not see their loan balances grow because of unpaid interest.

Don’t miss this point about SAVE: The plan eliminates 100 percent of the remaining interest for subsidized and unsubsidized loans after a scheduled payment is made.

Faced with those types of consequences, many struggling borrowers chose forbearance or deferment to avoid defaulting on their student loans.

A deferment or forbearance allows borrowers to stop making their monthly payments if they meet certain criteria, such as economic hardship. But in the long term, it can be brutal because interest accrues and capitalizes.

After 3½ years of student loan pauses because of the coronavirus pandemic, millions of borrowers will see their repayments resume on Oct. 1. But interest starts building again Sept. 1.

If you have a federal loan and are concerned about affording your payments, find out whether you qualify for the SAVE plan. And do it now.

You can sign up at studentaid. gov/SAVE. The Education Department is hosting a free webinar on Sept. 14 from 7 p.m. to 8 p.m. Eastern Standard Time. There will be an opportunity to ask questions. Go to Eventbrite and search for “Repayment 101: Get Help with Your Federal Student Loans.”

SAVE replaces the Revised Pay As You Earn, or REPAYE income driven plan. Borrowers who were on the REPAYE plan will be automatically enrolled in SAVE.

Interest capitalization on student loans has haunted borrowers for decades. SAVE can spare them of this one grief.