interst capitalization IBR PAYE

Missing IBR or PAYE certification is REALLY expensive

Michael Lux Blog, Student Loans 0 Comments

Unexpected costs are everywhere with student loans.  Interest grows on your loans every days and one mistake on payments and you get hit with late fees.

One mistake that can cost thousands of dollars comes with Income Based Repayment (IBR) or Pay As You Earn (PAYE) re-certifications.  You read that correctly.  Screwing up your IBR or PAYE re-certification can cost thousands of dollars.

How does this happen?

When you are on IBR or PAYE, it is possible that the monthly interest on your student loans is greater than your actual payment.  If this is happening, it means your balance is growing rather than shrinking with each payment.  While this situation is clearly far from ideal, it is a way that many borrowers tread water until they get a better paying job, or ultimately qualify for student loan forgiveness.

For borrowers in this situation, re-certifiying in a timely manner each year is critical.  The reason is capitalization of interest.  When your interest is capitalized, it means that it is added to your principal balance and that you start paying interest on that interest.

Typically, on PAYE or IBR, interest is not capitalized as long as you are on the program.  However, failing to re-cetify your income on time gets you kicked out of the program.  The instant you are kicked out, your interest is capitalized.  Even if you do eventually re-certify, that interest is added to your principal balance, and there is nothing that can be done about it.

An Example

Suppose you have a $100,000 federal student loan balance.  After finishing school it takes you just over a year to find you first job.  During this time you are on IBR or PAYE and your monthly payments are $0.  If your interest rate is 5%, it means that you now owe your original $100,000 plus the $5,000 of interest.

If you stay on IBR or PAYE, that $5,000 floats in limbo so long as you are enrolled in the IBR or PAYE plan.  During this time, no interest accrues on that $5,000.  The second you go off IBR or PAYE, it is added to your balance.  If you fail to re-certify on time, that $5,000 is immediately added to your $100,000 balance and you start paying interest on that interest.  If you fail to re-certify after that first year and then stay on IBR or PAYE for 10 years, the mistake will cost you approximately $2,500!  If you have higher interest rates, loan balances, or take longer to pay off your loans; the cost of a failure to re-certify is even more expensive.

Making things worse…

Federal loan servicers have done an incredibly lousy job when it comes to the re-certification reminders.  While the process of re-certifying is fairly simple, applying at the right time isn’t simple.  Lenders will tell you that the process can take 2 to 3 months, so submitting your tax records or pay stubs timely isn’t always simple.  Most servicers will only send a letter or an email reminding students.  These limited reminders do not explain the consequences of failing to re-certify on time.

Earlier this year the Department of Education revealed that over 57% of the people on IBR failed to re-certify on time.  With failure to re-certify being such an expensive mistake, people should not be missing this deadline.

Avoiding capitalization

If you are on IBR or PAYE, re-certifying on time each year is essential.  Set up a reminder on every calendar you have.  You can even email yourself in the future so that you don’t miss the deadline.  Best yet, email your lender to find out the deadline for your next re-certification application.  When you do get the reminders, don’t ignore them.  It is a really expensive mistake.