The big announcement on student loan forgiveness got all the attention, but the repayment plan announced on the same day could be the most important change.
In addition to student loan forgiveness and an extension of the payment and interest freeze, President Joe Biden announced a new income-driven repayment plan.
For some borrowers, the new IDR plan will be of little significance. For others, the savings could add up to far more than the $10,000 of forgiveness.
Biden’s New IDR Plan
Before jumping into the details, it is worth knowing that we are early in the process of creating a new repayment plan. It still has to go through the rulemaking process, and changes may happen.
However, rulemaking is significantly less politically challenging than creating new legislation, and Biden should be able to deliver on his promises.
Under the newly announced IDR plan, borrowers with only undergraduate loans will be required to pay only 5% of their discretionary income towards their federal loans. This change alone would cut payments in half for most borrowers.
Additionally, the discretionary income level measurement was changed. On repayment plans like IBR, REPAYE, and PAYE, discretionary income is your income minus 150% of the federal poverty level. Under the new IDR plan, discretionary income is earnings minus 225% of the federal poverty level. This means reduced monthly payments for all borrowers.
These changes alone would mean significant monthly savings for borrowers struggling to get by. However, the addition of one tiny detail makes this new repayment plan a game-changer…
How Biden is Lowering Interest Rates with the New IDR Plan
Under the new IDR plan, if your monthly payment does not cover the interest that accrues that month, the government covers the remaining interest.
This provision is designed so that borrowers don’t see their loan balances spiral out of control.
For a borrower who qualifies for $0 per month payments, it means their interest rate essentially drops to 0%.
However, this change impacts borrowers at all different income levels. The larger your balance, the higher your monthly interest charges.
Suppose a borrower qualifies for $100 per month payments under the new IDR plan. For reference, a person making about $55,000 per year could qualify for $100 per month payments under the new plan. If this borrower’s loan balance generated $150 per month in interest, the extra $50 would be forgiven each month.
If our hypothetical borrower had a 6% interest rate on their federal loans, it means the interest rate is effectively dropped to 4%.
Ending Capitalized Interest and Growing Balances
Under the new policy, borrowers with monthly payments lower than the monthly interest won’t see their balance grow.
This is a massive change. Right now, the best a borrower can do is sign up for REPAYE, which offers a 50% interest subsidy. All other plans charge full interest.
This extra interest isn’t immediately added to the borrower’s principal balance until an event causes the interest to be capitalized. In the time leading up to interest capitalization, many borrowers don’t realize their balance is growing. Once the interest capitalizes, borrowers start getting charged interest on the accused interest, which causes balances to spiral out of control.
The Catch
Covering excess interest is a significant policy change for borrowers.
However, not everyone benefits. If your monthly payment covers interest and a portion of the payment lowers your principal balance, the new provision won’t help you.
For the borrowers that do benefit, the policy may or may make a difference. If you are working towards PSLF, the size of the balance ultimately forgiven doesn’t matter.
The Biggest Benefit to Interest Changes
Suppose a student graduates and struggles to find a job. During that time, they make either very low payments or $0 payments. Instead of adding a couple of extra years worth of interest to the loan, the balance doesn’t move.
Once this recent graduate finds work, paying off the loan in full is more manageable because the balance didn’t grow when they struggled financially.
Enrolling in the New Repayment Plan
Before anyone can sign up for the new plan, it must get through the rulemaking process.
However, once the Department of Education finishes its work, borrowers can enroll using the standard IDR enrollment page on studentaid.gov.
