UNITED STATES DEPARTMENT OF EDUCATION 

 OFFICE OF POSTSECONDARY EDUCATION 

Issue Paper #3: Interest Capitalization

Session 1: October 4-8, 2021

Issue:

Statutory cites:

Regulatory cites:

Eliminate interest capitalization for non-statutory capitalizing events 

§428H(e)(2) of the Higher Education Act of 1965, as amended

34 CFR 685.209(a)(2)(iv), 685.209(c)(2)(iv), 685.202(b)(4), 685.202(b)(3), and 

685.220(f)(3) 

Summary of issues: Section 428H(e)(2) of the Higher Education Act of 1965, as amended, provides that 

interest capitalization occurs when any accrued, unpaid interest becomes part of the principal balance 

of a borrower’s loan. Capitalization is triggered by designated “capitalizing events.” Once interest is 

capitalized, it begins to accrue interest at the rate applicable to the loan. This ultimately increases the 

overall balance of the loan and typically increases the amount the borrower must repay. When 

capitalization occurs, borrowers see balances rise faster as interest accrues on interest. 

Interest capitalization is not a common practice across other consumer financial products, at least in 

part because Federal student loans afford more opportunities to pause or reduce payments. Auto loans 

do not provide common occurrences for interest capitalization. Mortgage interest typically only 

capitalizes with certain modifications. In addition, there are federal and state laws that prohibit 

capitalization of interest on certain consumer financial products and under certain circumstances. While 

student loans are a very different kind of financial product, capitalization can be a frustrating experience 

for borrowers who are confused as to what triggered the capitalization or surprised by the higher 

amount owed.

The Department has identified the following capitalizing events in regulation where we are proposing to 

eliminate interest capitalization on a more permanent basis:

• Failure to recertify enrollment on an income-driven repayment (IDR) plan — Borrowers are

required to recertify their participation in any income-driven repayment plan annually, but ED

data presented at a 2015 negotiated rulemaking session indicates that over half of borrowers

in an IDR plan fail to recertify on time. Additionally, researchers have suggested that

recertification is a significant barrier for lower income borrowers.

1

• Leaving an Income-Contingent Repayment (ICR) plan (PAYE, REPAYE, ICR) — While borrowers

switching across other types of repayment plans, such as standard and graduated, do not have

their interest capitalized, ICR borrowers do.

1 https://www.urban.org/urban-wire/structural-changes-student-loan-repayment-could-make-forgiveness-workbetter-struggling-borrowers
Interest Capitalization 2 

• Negative amortization under the ICR plan — Under the original ICR plan, borrowers whose 

payments do not cover accumulating interest see that interest capitalize annually until the 

capitalized interest reaches 10 percent or more of the original principal balance. Unpaid interest 

does not capitalize under the other IDR plans unless the borrower leaves those plans.

• Exiting forbearance — Borrowers often exercise forbearances because they are unable to afford 

their payments for a short period of time. Interest capitalization at the end of a forbearance 

period penalizes borrowers who are seeking to get on track.

• Entering repayment — When borrowers’ loans enter repayment for the first time, 

interest currently capitalizes when borrowers’ grace periods end.

• Default — For Direct Loan and ED-held FFEL loans the Department does not currently capitalize 

interest when a borrower defaults or exits default (unless the borrower consolidates to get out 

of default). For all commercially held FFEL loans, the guaranty agency managing a FFEL 

borrower’s defaulted loan capitalizes the interest when it pays a default claim to a lender. 

Solution: The Department is concerned that interest capitalization can significantly increase what a 

borrower owes and extend the time it takes to repay their loans. And there may be many circumstances 

in which borrowers are not even aware that capitalization may occur. The Department is proposing to 

eliminate capitalization events where it has the authority to do so, which are the instances identified 

above. In circumstances where interest capitalization is required by statute, the Department cannot end 

capitalization for borrowers. Instances where capitalization is required in statute include when the 

borrower exits a deferment period and when a borrower leaves the Income-Based Repayment plan.

Proposed Regulations:

To assist the Committee in discussing these issues, the Department is providing draft revisions to the 

regulatory language for the Direct Loan Program, incorporating the Department’s proposals. 

(Conforming changes will be made to FFEL regulations.)

§ 685.202 Charges for which Direct Loan Program borrowers are responsible.

(b) Capitalization. (1) The Secretary may add unpaid accrued interest to the borrower's unpaid principal 

balance. This increase in the principal balance of a loan is called “capitalization.”

(2) For a Direct Unsubsidized Loan or a Direct Unsubsidized Consolidation Loan that qualifies for a grace 

period under the regulations that were in effect for consolidation applications received before July 1, 

2006, or for a Direct PLUS Loan, the Secretary may capitalize the unpaid interest that accrues on the 

loan when the borrower enters repayment.

(23) Notwithstanding § 685.208(l)(5) and § 685.209(d)(3), for a Direct Loan not eligible for interest 

subsidies during periods of deferment, and for all Direct Loans during periods of forbearance, the 
Interest Capitalization 3 

Secretary capitalizes the unpaid interest that has accrued on the loan upon the expiration of the 

deferment or forbearance.

(4) Except as provided in paragraph (b)(3) of this section and in § 685.208(l)(5), and § 685.209(d)(3), the 

Secretary annually capitalizes unpaid interest when the borrower is paying under the alternative or 

income contingent repayment plans and the borrower's scheduled payments do not cover the interest 

that has accrued on the loan.

(5) The Secretary may capitalize unpaid interest when the borrower defaults on the loan

§ 685.209 Income-contingent repayment plans.

(a)(2)(iv)(A) Except as provided in paragraph (a)(2)(iii) of this section, accrued interest is capitalized —

(1) wWhen a borrower is determined to no longer have a partial financial hardship; or

(2) At the time a borrower chooses to leave the Pay As You Earn repayment plan.

(B)(1) The amount of accrued interest capitalized under paragraph (a)(2)(iv)(A)(1) of this section is 

limited to 10 percent of the original principal balance at the time the borrower entered repayment 

under the Pay As You Earn repayment plan.

(2B-) After the amount of accrued interest reaches the limit described in paragraph (a)(2)(iv)(B)(1) of this 

section, interest continues to accrue, but is not capitalized while the borrower remains on the Pay As 

You Earn repayment plan.

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(b)(3)(iv) Limitation on capitalization of interest. If the amount of a borrower's monthly payment is less 

than the accrued interest, the unpaid interest is capitalized until the outstanding principal amount is 10 

percent greater than the original principal amount. After the outstanding principal amount is 10 percent 

greater than the original amount, interest continues to accrue but is not capitalized. For purposes of this 

paragraph, the original amount is the amount owed by the borrower when the borrower enters 

repayment.

...

(c)(2)(iv) Any unpaid accrued interest is capitalized at the time a borrower leaves the REPAYE plan. 

Last updated 9/29/2021