IBR, PAYE and Growing Monthly Interest

The great part about Income-Based Repayment (IBR) and Pay As You Earn (PAYE) is that the monthly payments on your student loans are based upon your income, not the size of your student loan balance.

Borrowers who are thinking ahead realize that there is potentially a major problem with this approach.  If your monthly IBR or PAYE payments are less than the monthly interest on your student loans, won’t the balance go up?  Looking at your loan statements doesn’t really tell the story, because the balance appears to stay the same.

What happens to the interest?

Unfortunately, the government doesn’t just forget about the interest.  (Unless you have subsidized loans and are less than three years out of school – in that case, the government is actually paying the interest.)  When your monthly payment is less than the monthly interest, called a negative amortization, your balance will grow.

The misleading part about this process is that the statements you get from your lender may not indicate that your balance is actually growing.  This is where the good news comes in.  The monthly interest isn’t added to your balance until you leave IBR or PAYE.  Adding the interest to the principal balance is called capitalization, and one of the perks about IBR and PAYE is that interest does not capitalize so long as you are enrolled in IBR or PAYE.

Why is no capitalization a perk?

When the interest gets added to your principal balance, it means you are effectively paying interest on that interest.  If the interest is never capitalized, the balance grows at a slower rate.

Suppose you have a student loan balance of \$100,000 and an interest rate of 10% (you probably don’t, but it makes the math easier).  Suppose you are living right at the poverty line, so your monthly payment is zero dollars.  Each year your balance is growing by \$10,000 based on the original principal alone.  If that interest is capitalized after five years, your new balance will be \$150,000.  That means the interest payments alone will now be \$15,000 per year!

As long as you stay on IBR or PAYE your principal balance will never grow and the monthly interest will remain the same.  For larger balances and interest rates, this is a huge perk.

Be on the lookout…

Many loan servicers are being criticized for doing a lousy job reminding borrowers about the timing and deadlines to re-certify their income to stay on IBR or PAYE.  Failure to certify your yearly income means that you are no longer enrolled in IBR or PAYE.  The moment you are no longer enrolled, the interest capitalizes and your balance grows.  Moral of the story: Do not forget to submit your paperwork.

Capitalization on REPAYE

The newest Federal Repayment Plan, REPAYE adds a little wrinkle to the interest math.  If you are enrolled in REPAYE and your monthly payments don’t cover the interest, the Department of Education will pay 50% of the additional interest.  This means that if you eventually leave REPAYE, the interest balance added to your account will be half of what it would be under IBR or PAYE.  While REPAYE does have major drawbacks, this is a huge perk.

Bottom Line

Making super low payments on your federal student loans is nice, but putting off paying your principal debt does come at a cost.  That cost varies, but it is something that should be accounted for.

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