Yesterday, the New America Foundation’s Federal Education Budget Project released Safety Net or Windfall?: Examining Changes to Income-Based Repayment for Federal Student Loans, a report detailing how pending changes to the Income-Based Repayment (IBR) plan for federal student loans will affect different types of borrowers. The New York Times highlighted the report and noted that other policy experts agree with the report’s findings – namely that high-debt borrowers will receive the biggest increase in benefits even if they earn a high income. But one of those experts, FinAid.org founder Mark Kantrowitz, also called into question the way some of the numbers in the paper were calculated.
We would like to set the record straight with regard to Kantrowitz’s criticism. We have confirmed with student loan servicers, correspondence between student loan servicers and the U.S. Department of Education, and a careful review of the federal statute, that our analysis and calculations are, in fact, accurate.
The disagreement referenced in the Times arose over how borrowers’ payments are credited to outstanding loan balances under IBR. According to the legal statute, a borrower’s payments must first go to any unpaid interest, before payments go to pay down the original loan (the principal). FinAid.org hosts an IBR calculator that in some cases erroneously credits a borrower’s payments not to owed interest, but to principal. The New America Foundation calculator follows the IBR statute and always credits payments to any interest owed before it applies it to the principal.
That distinction makes a significant difference in how much a borrower owes over the life of his loan and how much loan forgiveness he receives. To understand how this happens, let’s quickly review how borrowers repay their loans through IBR.
Because a borrower makes payments based on his income under IBR, it is possible that his payments are too low to pay off the full amount of interest that accrues on his loans each month. For example, a borrower with $145,000 in loans and a starting salary of $75,000 who enrolls in the new IBR program (set to take effect around the end of 2012) will pay $485 a month, not enough to cover the interest that accrues. So by the end of the first year, he has $4,144 in unpaid accrued interest. While that unpaid interest is not added to his loan balance as long as he qualifies for IBR—he isn’t charged interest on the interest—he still must pay it before he can pay off the principal balance on this loan.
Assume then that the same borrower’s income jumps to $150,000 in his eighth year of repayment. He still qualifies to repay through IBR at that income level, but his monthly payment is greater than the interest that accrues each month. What happens to the excess payment, the portion of the payment that more than covers one month’s interest? Is it credited to the accumulated unpaid interest from prior years, or is it instead credited to the original $145,000 loan, the principal?
According to the statute mentioned above, the excess payment must first go to the unpaid interest. Correspondence between student loan servicers and the U.S. Department of Education, as well as a careful interpretation of the law, confirm that this is how the servicing companies have been instructed to administer the IBR program. All unpaid interest must be paid off before the borrower’s payment can begin to reduce the $145,000 principal balance on his loan. To read the statute yourself, check out §493C(b)(2) of the Higher Education Act, or 34 CFR 685.221(c).
A calculator that credits the borrower’s payments to the principal balance before it credits the payments to the unpaid interest from prior months will severely under-estimate the total amount a borrower will owe over the life of the loan. It shows that a borrower’s principal will decrease at a faster rate than it actually would as that borrower repays through IBR. At the same time, it shows that the borrower will owe less interest over time, as well, because that interest accrues on a smaller amount of principal.
Thus, the FinAid calculator understates the total interest that the borrower will owe or have forgiven in certain circumstances. In the scenario outlined above, the FinAid calculator shows that the borrower has $56,947 forgiven. But the correct figure is actually $94,634, as shown by the New America Foundation calculator. (A spreadsheet is available here showing the full calculation using the New America Foundation IBR calculator.)
The confusion makes one thing obvious: Income-Based Repayment is so labyrinthine in its many nuances and rules that even researchers struggle to understand every component. That said, the New America Foundation calculator –and the findings in our report – accurately reflect how the IBR program works.