PAYE interest capitalization limit?

[orthostice]

I wanted to check with someone who had more experience with PAYE on one of the terms. Looking at the ed.gov website, it makes it sound like interest doesn't accumulate on the loan balance if you have a 'partial financial hardship.'

Let's say I borrow $75k a year for each of four years of med school. During each of those years, my income is 0, so my PAYE payments are 0. Since interest can't be capitalized, I pay no interest. I graduate med school owing $300k.

Then I'm a resident. Let's say my AGI is $45k. My PAYE payments are capped at 10% of my AGI, so each year I pay $4500. Let's say I have a blended 6% rate on my loans. 6% of 300k is $18k. Since my $4500 payment cap set by PAYE is less than the interest owed, I pay only the $4500 each year. Again, since interest cannot be capitalized, my loans stay fixed at $300k.

Then I finish residency. At this point, I owe $300k, and now (assuming I no longer have financial hardship) I face a real 6% interest rate on that principal owed.

This seems like too good a deal to be true. Is this really how it works, or am I missing some important provision of the loan?

The site I referenced:

http://studentaid.ed.gov/repay-loans/understand/plans/pay-as-you-earn

The text there:

"Limitation on the capitalization of interest—While you have a partial financial hardship, interest that accrues but is not covered by your loan payments will not be capitalized, even if interest accrues during adeferment or forbearance. Unpaid interest capitalizes if you are determined to no longer have a partial financial hardship, but the total amount of interest that capitalizes while you are repaying your loans under the Pay As You Earn plan is limited to 10% of your original principal balance when you begin paying under Pay As You Earn. "

---

Members don't see this ad.

 

[freaker]

That's not quite how it works. Capitalization means that the interest that accumulates on your principal does not also accumulate interest. Not having capitalizing interest is a very good thing--particularly for students with large debts who will go through a long period before they can begin repayment in earnest. You still pay interest on the principal throughout the entire duration of your loan.

 

[RangerBob]

A few points:

1: Interest accrues during medical school on all non-subsidized loans. You cannot enroll in PAYE while in medical school because your loans are not in repayment (they're in in-school status). After your six month grace period/when you begin repayment (PAYE, IBR, or standard), the interest accrued (probably around 40-60k if you borrow 300k) will capitalize and thus be added to the principle. So if you borrowed 300k for medical school, you'll now owe 300K plus the four years of interest. That entire amount (lets just pretend it's 350k) will now accrue interest. However...

2: After entering PAYE/IBR, interest won't capitalize--it just sits in "limbo" as long as you're in the program. This save you a lot of money because if you can't cover the interest payments, then the interest you can't pay off will not accrue interest itself, which is what capitalization is. However, the interest is still accruing on that 350k, and the government will only subsidize the unpaid interest on your subsidized loans.

3: When you no longer qualify for PAYE/IBR (or forget to re-enroll) all that interest will be capitalized. And unless you pay off your interest during residency, upon becoming an attending you will now owe the $350k in principle (your original principle plus interest capitalized upon starting repayment) plus perhaps another $50-300k in interest depending on how much you pay during residency and how long it is.

4: If you do owe that much money, there's a good chance that you will still qualify for PAYE/IBR, and that the additional interest accrued during residency won't be capitalized. When you make payments that interest will get paid first, but you can always pay off your higher interest loans first while your lower interest loans accrue interest that isn't capitalizing, which will overall save you money. Of course you will also be making your monthly PAYE payments during this time as well.

As far as the 10% limit, that's not something I know much about (I only qualify for IBR, and that's a benefit that only applies to PAYE, I believe).

Regardless, you will save a lot of money by entering PAYE (unless you can afford to pay more). You don't pay a whole lot back per month under PAYE, but it's something and prevents your loans from ballooning as much as they could, and the fact your interest doesn't capitalize while in the program saves you quite a bit over the years.

Unless it's a huge hardship, I think every resident should at least be enrolled in PAYE or IBR. When it comes to taxes and loans, it's wise to know what the government "pays" you for. And it's essentially paying you by not capitalizing your interest while in the program, and also for those of us with subsidized loans, by making up for the shortcoming between our monthly payment and the interest accruing on our subsidized loans, the latter of which should save me about 6k or so over three years. I imagine I'll save far more in the prevention of capitalization, but I don't feel like calculating it right now!

 

[Postictal Raiden]

A few points:

1: Interest accrues during medical school on all non-subsidized loans. You cannot enroll in PAYE while in medical school because your loans are not in repayment (they're in in-school status). After your six month grace period/when you begin repayment (PAYE, IBR, or standard), the interest accrued (probably around 40-60k if you borrow 300k) will capitalize and thus be added to the principle. So if you borrowed 300k for medical school, you'll now owe 300K plus the four years of interest. That entire amount (lets just pretend it's 350k) will now accrue interest. However...

2: After entering PAYE/IBR, interest won't capitalize--it just sits in "limbo" as long as you're in the program. This save you a lot of money because if you can't cover the interest payments, then the interest you can't pay off will not accrue interest itself, which is what capitalization is. However, the interest is still accruing on that 350k, and the government will only subsidize the unpaid interest on your subsidized loans.

3: When you no longer qualify for PAYE/IBR (or forget to re-enroll) all that interest will be capitalized. And unless you pay off your interest during residency, upon becoming an attending you will now owe the $350k in principle (your original principle plus interest capitalized upon starting repayment) plus perhaps another $50-300k in interest depending on how much you pay during residency and how long it is.

4: If you do owe that much money, there's a good chance that you will still qualify for PAYE/IBR, and that the additional interest accrued during residency won't be capitalized. When you make payments that interest will get paid first, but you can always pay off your higher interest loans first while your lower interest loans accrue interest that isn't capitalizing, which will overall save you money. Of course you will also be making your monthly PAYE payments during this time as well.

As far as the 10% limit, that's not something I know much about (I only qualify for IBR, and that's a benefit that only applies to PAYE, I believe).

Regardless, you will save a lot of money by entering PAYE (unless you can afford to pay more). You don't pay a whole lot back per month under PAYE, but it's something and prevents your loans from ballooning as much as they could, and the fact your interest doesn't capitalize while in the program saves you quite a bit over the years.

Unless it's a huge hardship, I think every resident should at least be enrolled in PAYE or IBR. When it comes to taxes and loans, it's wise to know what the government "pays" you for. And it's essentially paying you by not capitalizing your interest while in the program, and also for those of us with subsidized loans, by making up for the shortcoming between our monthly payment and the interest accruing on our subsidized loans, the latter of which should save me about 6k or so over three years. I imagine I'll save far more in the prevention of capitalization, but I don't feel like calculating it right now!

I have a hypothetical question.

Let's say that I finish med school with a debt of 450K (undergrad, med school, and interest). Then I enroll in PAYE. During a 6-year residency and fellowship, the accumulated unpaid interests (~23K/year) that are in the "limbo" will be ~140K. On the last day of my training, I win the lottery and immediately decide to pay off my entire debt. Will I pay only the principle 450K or 590K (the principle plus the interest it accrued over the 6 year training period)?

 

[orthostice]

Thanks for your responses, I really appreciate them. The world you're describing makes a lot more sense -- I understand what they mean now when they talk about limits on interest capitalizing.

 

[sazerac]

I have a hypothetical question.

Let's say that I finish med school with a debt of 450K (undergrad, med school, and interest). Then I enroll in PAYE. During a 6-year residency and fellowship, the accumulated unpaid interests (~23K/year) that are in the "limbo" will be ~140K. On the last day of my training, I win the lottery and immediately decide to pay off my entire debt. Will I pay only the principle 450K or 590K (the principle plus the interest it accrued over the 6 year training period)?

590K

The only "limbo" is: you are saved from paying interest on your interest. It's still your interest, though.

 

[Postictal Raiden]

590K

The only "limbo" is: you are saved from paying interest on your interest. It's still your interest, though.

I see.

On a side note, I will need to be making at least 540K/year as an attending to payoff my project debt (the principle amount) within the duration of my PAYE repayment plan. This will only happen if I go into a lucrative specialty, salaries don't get cut, and salaries keep up with inflation. In other words, the likelihood of not utilizing the forgiveness feature is very slim.