By Juliet Drury
This month marks a transformational shift in the federal student loan system. Changes include an increase in a temporary interest rate reduction that should benefit many borrowers, but also a reshuffling in the terms that mean many borrowers won't be able to borrow as much or will have to pay more for loans they already took out.
First the good news: borrowers signed up for automatic payments will experience a temporary increase their interest rate reduction. The rate reduction will rise to 1 percentage point from 0.25 percentage points and is available for borrowers with direct loans disbursed on or after July 1, 2012. It lasts through June 30, 2028, as long as borrowers keep auto pay and remain current on loans. Borrowers can sign up for automatic payments to receive this benefit.
The other changes are more complex and could negatively impact many borrowers, although they should lead to less student debt in aggregate and could lead to lower costs for higher education in the future. The changes include caps on borrowing and the phasing out of certain income-based loan forgiveness plans. According to BofA Global Research, Americans collectively hold roughly $1.8 trillion in student loan debt. More than half of federal borrowers owe less than $20,000, while about 10% carry balances exceeding $100,000.
Unprepared borrowers. As of February, a majority of borrowers were unprepared for what comes next, according to research conducted by Credible, a website that allows borrowers to compare interest rates on loans. The survey found 61% of borrowers don't feel prepared for the federal student loan changes, while 63% say that they are unaware of the new rules. Financial advisors can play a role in helping clients confront this changing landscape.
One of the biggest shifts affects the Biden-era Saving on a Valuable Education (SAVE) repayment plan. It is being dismantled, requiring borrowers to choose a new repayment option. Borrowers enrolled in SAVE who don't select a new repayment plan will default to the standard repayment plan, potentially increasing their monthly payments.
For new federal loans issued after July 1, borrowers will choose between the new Repayment Assistance Plan (RAP) and the Tiered Standard Repayment Plan. Current borrowers who don't take out additional loans can switch into RAP, or remain on their existing plan. Borrowers can research their options at the Federal Student Aid website.
According to Credible, income-based plans being phased out offer loan forgiveness after 20 to 25 years of payments, while the Repayment Assistance Plan requires 30 years before any remaining balance is forgiven.
The federal student loan changes also eliminate Graduate Plus loans, federal loans available to graduate and professional students. Additionally, new borrowing limits will apply to Parent Plus loans, the federal loan program available to parents of undergraduate students.
Awareness gap. Despite the widespread impact of the federal student loan changes, most Americans were unaware of the transition earlier this year, according to Credible's research. Most respondents also said the federal government hasn't clearly explained what borrowers should expect.
Communication gaps may be one of the most significant challenges for borrowers throughout this transition. Constantine Yannelis, a professor of financial economics at Cambridge University, recently wrote in a Barron's commentary that many borrowers stop paying or fall into delinquency because they are "simply confused" and "lack information about how to avoid falling into default."
Ripple effects. The federal student loan overhaul is predicted to reshape future borrowing decisions, according to Credible. Half of survey participants believe the new rules will increase reliance on private lenders, which generally offer fewer borrower protections than federal loans. Nearly one-quarter of Americans said the new Repayment Assistance Plan makes them much less likely to borrow through federal student loans. Among current borrowers, 30% said they would be less likely to borrow if federal loans no longer covered the full cost of attendance.
The implications of the overhaul extend beyond borrowing decisions to higher education and career planning. More than one-quarter of borrowers said they are reconsidering their education goals because of the policy change. Overall, 65% of Americans believe the changes will discourage people from attending college, while 58% believe they will influence career choices. Nearly one in five respondents said the changes have already affected their plans to pursue graduate or professional school.
Survey respondents told Credible that student loan debt had already affected their savings, ability to pay off other debt, buy a home, make retirement plans, and travel.
Advisors' role. Financial advisors with clients who have children who took out student loans in the past should make sure eligible families are taking advantage of the opportunity to pay a lower interest rate for the next few years by signing up for automatic payments.
They should also reach out to families where students are planning to pursue graduate programs and may be discouraged by the new rules. Advisors can help families determine how much they can borrow and if they can help fund a child's education using other means if there are shortfalls.
Credible's survey suggests a major challenge for the U.S. Department of Education will be addressing the knowledge gap among borrowers. How families weather the transition may depend on if they have an advisor who understands both the program's details and their clients' long-term goals.
This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.