How does capitalized interest work on student loans?
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When you take out student loans, you pay back more than you borrow because of the interest charged on the loan balance. But sometimes, unpaid interest gets added to the balance, which is called interest capitalization. When this happens, you end up paying interest on a higher loan balance, increasing your total repayment costs.
According to a survey by the Pew Charitable Trusts, around 40% of student loan borrowers owed more than what they had originally borrowed. In order to avoid capitalized interest, learn what can trigger it and how it works.
Capitalized interest is unpaid interest on your student loans that gets tacked onto your principal balance. When interest capitalizes, it can increase not only your total loan balance, but your monthly payment, too.
Interest capitalization increases borrowing costs because it means you’re paying interest on a higher balance. The good news is that only certain events result in interest capitalization, and they vary based on the type of student loan you have.
Let’s say you have a $25,000 federal unsubsidized loan with an interest rate of 5.50%, and you’re on the standard 10-year plan. You enter deferment for one year. During that time, $1,375 of interest would accumulate.
When the deferment ends, that interest would be added to the $25,000 principal balance, and you’d now owe $26,375. Your monthly payment would jump from $271 to $286. That might not seem like a lot in the short term, but in the long term it adds up. The total amount you’d owe would increase by $1,791.
Loan balance | Monthly payment | Total interest owed | Total costs | |
|---|---|---|---|---|
Before capitalization | $25,000 | $271 | $7,558 | $32,557 |
After capitalization | $26,375 | $286 | $7,974 | $34,348 |
When interest gets capitalized on student loans varies by type of student loan, but it only happens during certain periods.
Thanks to major student loan reform by the Biden administration, many events that would trigger capitalization for federal student loans have been eliminated due to regulations implemented on July 1, 2023. Some of these events included when borrower’s entered repayment, after periods of forbearance, and when loans entered default. It’s important to note that this doesn’t apply retroactively, but going forward borrowers can benefit from this significant change.
Interest capitalization still occurs with federal Direct Loans and Federal Family Education Loans (FFEL) managed by the Department of Education in the following instances, set by law:
- After periods of deferment on Direct Unsubsidized Loans and Direct PLUS Loans
- If you’re no longer eligible for Income-Based Repayment (IBR) or leave the plan
- When you consolidate with a Direct Consolidation Loan
Good to know:
If you have Direct Subsidized Loans, the government pays interest that accumulates during a deferment, which helps prevent capitalization.
Since private lenders set their own loan terms, check with your specific lender about when interest can capitalize. In general, interest will continue to accrue on private student loans during all periods of deferment and forbearance. This includes while you’re in school and the six-month grace period after leaving. This accrued interest may capitalize after your grace period ends, and after any requested periods of deferment or forbearance.
You may be able to lower your repayment costs by preventing interest from capitalizing. Here’s what you can do:
- Make interest-only payments: Make interest-only payments while your payments are paused — like while you’re in college and during your grace period. Paying all interest that accrues during deferment or forbearance means there won’t be any interest to capitalize once payments resume.
- Consider a lump-sum payment: You can also make a lump-sum interest payment before the interest on your loan gets capitalized. For example, before your deferment period ends, you could pay off all of the accrued interest.
- Avoid deferment: Since capitalized interest most commonly happens after deferments, the easiest way to avoid it is to look at alternatives. Federal loan borrowers can sign up for an income-driven repayment (IDR) plan, which can reduce monthly payments. In some cases, you may qualify for a $0 payment.
Capitalized interest refers to any unpaid interest being tacked onto your principal balance. This increases your principal balance, which means you’ll pay more in interest. Accrued interest refers to the interest charges that accumulate between monthly payments.
Interest starts accruing immediately on the majority of federal and private student loans. So as soon as the loans are disbursed, interest begins to accrue. An exception to this is federal Direct Subsidized Loans, as the federal government pays the interest that accrues while a borrower is in school and during periods of deferment.
Interest is the cost of borrowing, so when unpaid interest accumulates, it gets added to your principal balance. Student loan borrowers are responsible for paying capitalized interest at certain times. For federal unsubsidized student loans managed by the Department of Education, interest capitalizes after a period of deferment or if you leave or are ineligible for the Income-Based Repayment (IBR) Plan. Private loan interest typically capitalizes after a grace period, or after a period of deferment or forbearance.
Interest may capitalize on private student loans after a deferment or forbearance, or when your grace period ends. At this time, any unpaid interest on the loan is added to the total principal balance. Interest capitalization increases the outstanding balance and can result in higher monthly payments.
Meet the contributor:Melanie Lockert
Melanie Lockert is a freelance writer and the founder of the blog and author of the book, “Dear Debt.” Through her blog, she chronicled her journey out of $81,000 in student loan debt. Her work has appeared on Allure, Business Insider, Credit Karma, Fortune, and more.
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