: Why some student-loan balances grow — even if you’re making diligent payments

The way most of us envision paying down a debt is through amortization — or where the balance reduces as you make payments. But often with student debt, the interest is so high and the borrower’s income so low, that payments only cover the interest, causing the balance to increase even as borrowers send money to their student-loan company every month. 

It’s not just my inbox that indicates this experience is relatively common; the data backs it up too. Of borrowers who had outstanding student debt in 2009, more than 25% had a larger balance by 2019, according to an analysis by economist Marshall Steinbaum published last year by the Jain Family Institute. Roughly 10% of borrowers saw their debt grow four times its 2009 levels by 2019. 

How is student loan interest affecting your balance? We want to know. Email jberman@marketwatch.com.

In this week’s Extra Credit — MarketWatch’s weekly look at the news through the lens of debt — we’ll explore how we got here. But first, let’s get back to Hartenstein. 

Hartenstein decided to pursue a master’s of science degree in counseling because it seemed like a field that fit with his interests and that would provide him with a satisfying career he could grow into. He also looked around at the job market in 2008, when he was graduating from college, and, like many, thought it would make sense to spend more time in school. 

“I just felt like nothing was going to change when I walked off the stage with my bachelor’s,” he said. 

But even with the graduate degree, Hartenstein was only earning about $15 an hour after leaving school.

Squeezed for funds to afford his student-loan payments, Hartenstein decided to put his loans into forbearance, a status that pauses payments, but where interest accrues — in his case at around 8%. Eventually he found the courage to check his balance and was shocked to discover how much it had grown. 

Hartenstein switched to a payment plan that allowed him to repay the loan as a percentage of his income, but his salary was so low that the payments didn’t cover more than interest.

Frustrated with his lack of progress on the student-loan payments, Hartenstein decided to give up his career in mental-health counseling in hopes of earning more money. He started working full-time in real estate — and had done since the age of 19, but up until that point had just been a side job. Despite his higher salary, the student-loan balance continued to grow. 

Hartenstein’s predicament is the result of a series of choices by policymakers both about the amount student-loan borrowers are charged in interest and the structure of repayment plans that can make the interest difficult to tackle. Let’s dig into how we got here. 

Student-loan interest rates: 

Right now, the rates on new student loans are set based on the May 10-year Treasury auction plus a spread, which is larger for graduate students and parents. That means the cost to borrow a student loan is influenced by the current interest rate environment. Federal student-loan interest rates are fixed over the lifetime of the loan, so if borrowers took out their debt during a higher interest rate environment, they’ll be paying a higher rate. 

The government has set interest rates this way since 2013, but borrowers who took out their loans before then have a rate lawmakers determined in a different way. Though they vary, lawmakers’ historical approaches to student-loan interest rates have one thing in common, said Bob Shireman, a senior fellow at the Century Foundation, a progressive think tank. 

“It is basically a political decision made by Congress based on whatever seems to make sense at the time and what works for the cost estimates,” said Shireman, who has worked on student-loan policy in various capacities on Capitol Hill and in the White House since the late 1980s. 

Lawmakers may expand a program — say, loans for graduate school or undergraduate loans where students are charged interest while in college — so they can afford to pay for something else within whatever budget constraint they’re given, Shireman said.

Before 2010, when Congress cut commercial middlemen out of the student-loan program, interest rates were also, at times, influenced by private lenders who warned they would stop lending to students if they didn’t receive a high enough subsidy. 

A repayment program designed to allow balances to grow

It’s not just high interest rates that keep some student-loan balances growing, it’s also the way policymakers designed some of the government’s repayment plans. 

In 1992, Congress expanded the loan program to include all students regardless of income. As part of the change, loans made to this new group of borrowers with higher incomes would accrue interest while students were in school. Previously, when student loans were limited to low-income borrowers, the government subsidized the interest while they were in college. 

“At that moment Congress made the decision that negative amortization — so a growing loan size — while people are in school is okay,” Shireman said. 

That comfort with negative amortization continued when, during the same period, Congress created a program that allowed borrowers the opportunity to repay their debt as a percentage of their income for the first time. 

Lawmakers assumed that a growing balance in a borrower’s early years of repayment, while their income was still low, would eventually shrink as their income grew, Shireman said. Letting the interest build early on allowed the government to recoup the bulk of the funds it lent to these borrowers who were ultimately successful in the labor market. 

For borrowers whose incomes stayed perpetually low, there was an escape hatch — debt cancellation after 20 or 25 years of payments. “The theory was …that this is just a phantom loan amount, it’s not real, it’s not going to be repaid so we should not worry about it,” Shireman said. 

Fast forward 20 years and the reality of the program looks much different. Just 32 borrowers have been able to access cancellation through the income-driven repayment program and 2 million borrowers have been paying on their debt for more than 20 years, according to an analysis published earlier this year by the National Consumer Law Center. 

Advocates and borrowers have said student-loan servicers — the companies that manage the repayment process on behalf of the government — have actually made it more difficult for borrowers to stay on track towards having their debt cancelled. 

“It’s created these situations that are awful for people,” Shireman said. 

“All of this was just a choice about the design of the program,” Shireman added. Theoretically, you could design an income-driven repayment program that caps the amount the debt builds, he said. But that’s not what happened. 

How much you pay is hard to predict: 

Federal student loans have other features that allow the interest to build in ways that are different from other debt products — and can make their total cost hard to predict. 

Unlike most private loans, federal student loans offer borrowers the right to defer their payments, put their debt into forbearance and to switch among many repayment plans. 

While those benefits provide borrowers with insurance against a low income, they also create opportunities for the interest to build. When a borrower with an unsubsidized loan exits the six month grace period between when they leave school and start making payments, the unpaid interest capitalizes — or is added to the principal of the loan. That means borrowers become responsible for interest on interest. 

The same thing happens when a period of deferment on an unsubsidized loan ends, forbearance on any kind of loan ends, borrowers leave certain repayment plans, and more. 

Those components combined with programs like income-driven repayment, mean that as John Brooks and Adam Levitin, professors at Georgetown University Law Center, write “it is not an exaggeration to say that a student borrower cannot know,” before they borrow, based on projections, “how much the borrowing will ultimately cost.” 

That was the case for Hartenstein and only recently has he stopped blaming himself for not predicting how much the loan would grow over time. That realization has helped him come to terms with the idea that his master’s degree could still be a valid investment, even if he isn’t using it directly for his job. 

“I forgave myself for not understanding how the interest was going to compound and affect me,” Hartenstein said. He felt comfortable with the idea of spending $50,000 for a degree from a reputable program in a field he was passionate about. But $100,000? “no, that wasn’t where I was at, at the time,” he said.  

Policy choices that make getting an education a high stakes endeavor

The policies that have allowed balances to grow have implications for the borrowers holding the debt, like Hartenstein. But it also sends mixed signals about the purpose of the student-loan program, said Persis Yu, the director of the Student Loan Borrower Assistance Project at the National Consumer Law Center. 

Policymakers and educators often frame federal student loans as a tool of economic mobility because they provide an opportunity for students to attend college that might otherwise not have been able to afford it. But as Yu notes, “it’s expensive debt.” 

“Is it really a tool of access if it’s really expensive?” she said. “That gets to the heart of the question about student-loan debt. The way that we’ve structured student loans makes the stakes so high if you fail,” particularly for low-income borrowers, she said. 

As for Hartenstein, he’s making minimal contributions to his 401(k) and avoiding vacations and “little extras,” like new dress shirts until his debt is paid off. He’s not in favor of completely wiping student-loan borrowers’ debt away through some kind of mass-cancellation program. But he wonders why there aren’t “healthy conversations taking place about the legitimacy of interest.” 

Hartenstein says when he discusses his situation with people who don’t have student loans, “they’re always shocked.”

“They have no idea that that sort of interest is applied and compounded the way that it is on student loans,” he said.