/ Student Debt E-book
Interest Accumulation and Capitalization
IDR Plans, have many perks, but also have some downsides. Two of these are interest accrual and capitalization.
Because IDR plans calculate your monthly payments based on a percentage of your discretionary income, rather than the amount necessary to pay off interest every month, you may accumulate large amounts of unpaid interest (often termed accrued interest). And since your monthly payments are required to be allocated to accrued interest first, it is possible that you could be paying off very little of the actual loan principal.
Aside from accrued interest, another downside to IDR plans is capitalization. Capitalization is defined as “the addition of unpaid accrued interest to the principal balance of your loan.” Capitalization results in an increase in the actual amount you pay, over the total life of the loan. Capitalization can be thought of as paying “interest on interest.”
Capitalization does not normally occur in IDR plans, but can occur in five circumstances with an IDR plan:
- Your discretionary income rises to a point where you no longer have a partial financial hardship (IBR and PAYE plans).
- You switch from an IDR plan to another repayment plan.
- You fail to recertify your income annually.
- While enrolled in an IDR plan, you enter into a forbearance or deferment. Upon the ending of each forbearance and/or deferment period, all accrued interest capitalizes.
- When enrolled in the ICR plan – but subject to the restrictions in the note below.
Note: Both the PAYE and ICR plans possess capitalization restrictions. Under these plans, capitalization will cease when the outstanding principal balance on your loans is 110% of what it was when you initially entered the PAYE or ICR plan(s).
Interest Accrual Protections under the IDR Plans
The PAYE, REPAYE and IBR plans do provide interest accrual protections. Under each plan, the government pays all accrued interest on subsidized loans or the subsidized portion of a consolidation loan for the first three years of repayment. The REPAYE plan provides an additional protection as the government also pays 50 percent of accrued interest after the three-year period ends.
- The ICR plan provides no interest accrual protections but does, as noted above, limit the amount of interest that can be capitalized.
- The COVID-19 emergency relief measures set the interest rate on federally-held student loans to zero percent from March 20, 2020, through August 31, 2022.
Married Borrowers and the IDR Plans
If you are married while repaying your federal student loans, it is important to understand how your spouse’s federal student debt and income can affect your monthly payments under an IDR plan.
For the purposes of determining a partial financial hardship (PAYE and IBR): Your spouse’s annual gross income (AGI) and federal student debt is combined with yours to determine if you have the necessary partial financial hardship to enroll in the plan. However, this only occurs if you file your taxes “married jointly.” If you file your taxes married separately, then only your AGI and federal student debt will be considered.
If you do decide to file your taxes “married jointly”:
When calculating a partial financial hardship, you add the total federal loan amount for you and your spouse, add your AGIs, and then calculate as normal. You simply consider: would the Standard Repayment Plan (10 years) monthly payment on the combined federal student debt be more than ten percent (PAYE and IBR-new borrowers) to fifteen percent (IBR-old borrowers) of combined discretionary income? If so, you and your spouse possess the necessary partial financial hardship, and both of you can repay your loans under the PAYE and/or IBR plans.
For the purposes of calculating monthly payments (all plans):
REPAYE: Both you and your spouse’s income and federal student loan debt is used to calculate monthly payment amounts, regardless of whether you file your taxes “married jointly” or “married separately.”
PAYE, IBR, and ICR: Both you and your spouse’s income and federal student loan debt is used to calculate monthly payment amounts if you file your taxes “married jointly,” and not “married separately.”
Even if your spouse’s income and debt is considered, your monthly payments are based on your own portion of the total federal student loan debt and your spouse’s are based on his/hers. Consider the following example:
Bob and Sherry, a married couple, possess a household AGI of $160,000, each making $80,000 a year. Bob has $150,000 in federal loans, and Sherry has $300,000 in federal loans. What would each person be required to pay under the IDR plans?
- First, ask how much you want to pay under an IDR plan based on combined federal student loan debt and combined AGI.
Bob and Sherry have a combined AGI of $160,000 and a combined federal loan debt of $450,000. They would pay $1,695 under IBR, $1,130 under PAYE, $1,130 under REPAYE, and $2,076 under ICR.
- Second, you must determine what portion of the total monthly loan payment each person is responsible for.
To do this, as noted above, you ask what portion of the combined federal loan balance you are responsible for, then multiply that amount by the total loan payment.
Since Bob has $150,000 of the $450,000 in total loans, he has one-third of the total loan debt. This means that Bob pays one-third of the required monthly payment under each of the IDR plans. Bob would be responsible for monthly payments of $377 under REPAYE, $377 under PAYE, $565 under IBR, and $692 under ICR.
Sherry has $300,000 of the $450,000 in total loans and occupies two-thirds of the total loan debt. This means that Sherry pays two-thirds of the required monthly payment under each of the IDR plans. Sherry would be responsible for monthly payments of $754 under REPAYE and PAYE, $1,130 under IBR, and $1,384 under ICR.
Reminder: The loan simulator can also do calculations for married borrowers. This example is for informative purposes.
Another point to emphasize when discussing the effect of spousal income and debt on your monthly payments under the IDR plans is the Repayment Plan exception.
As noted above, all IDR plans except the REPAYE plan only consider the spouse’s income and debt if taxes are filed married jointly and not married separately. This gives you more choice to decide when you want to use your spouse’s information and when you do not.
However, for the REPAYE plan, the spouse’s information is ALWAYS used. This can sometimes make the REPAYE plan undesirable, despite the plan requiring you pay the lowest amount of discretionary income (ten percent) on your federal student loan payments.
Example: Suzie and Jeff, a married couple, possess a household AGI of $150,000, each making $75,000 a year. Suzie has $120,000 in federal loans; Jeff has no federal student loans. What would Suzie be required to pay under the IDR plans?
Under the PAYE plan, if Suzie files her taxes married separately, she would pay $422 a month on her loans. However, under the REPAYE plan, Suzie would pay $1,047 a month in student loans, regardless of how she files her taxes.
The REPAYE plan’s requirement of always considering the spouse’s information can get expensive. In cases where the spouse is a high earner, it may be worthwhile to consider other IDR plans, even where the percentage of discretionary income you pay is higher. For example, under the IDR plan, which requires fifteen percent of discretionary income as compared to the ten percent required by the REPAYE plan, Suzie still only pays about $633 a month if she files taxes “married separately.”
Note: Regardless of how you file your marital tax returns, if you are separated from your spouse or unable to reasonably access your spouse’s income information, only your individual income will be used to calculate your monthly payment amount under any of the IDR plans.