Understanding Capitalized Interest and How to Avoid ItAugust 27, 2021
When you borrow money for school, interest starts accruing right away on most loans. But you may not always make payments immediately, so the amount of interest you accrue will keep growing. Eventually an event, such as entering repayment, causes interest to capitalize.
What is capitalized interest on student loans? It’s simple. It occurs when unpaid loan interest is added onto the principal balance of the loan. Unfortunately, once the unpaid interest makes the loan balance larger, repaying loans becomes costlier.
Read on to learn more about how this process works and how to avoid capitalized interest on student loans.
What is capitalized interest on student loans?
Before we discuss what capitalized interest is, it’s important to understand student loan principal vs. interest. When you get a loan, the principal is the amount you initially borrow. For example, if you take out a $10,000 student loan, you start with a $10,000 principal balance. The lender then begins to charge interest, which is a percentage of your balance.
Usually, when you make payments on your loans, the amount affects both your interest and principal totals. But, many people don’t begin paying their student loans right away. In fact, it’s common for students to go years without making a payment because payments are deferred while they are in school and during a post-graduation grace period.
If you aren’t paying enough to cover interest costs, the unpaid interest keeps growing. This happens on private student loans as well as on federal student loans, with the exception of Direct Subsidized Loans, where the government covers interest costs while payments are deferred.
Eventually, an event occurs that triggers capitalized interest on student loans — unless you’ve paid off your full interest balance before that occurs. When that happens, the unpaid principal is added to your loan principal.
For example, say your $10,000 loan at 6% interest had gone unpaid for 48 months while you were in school. If interest capitalized annually, your loan balance upon graduation with interest added on would be $12,624.77 instead of $10,000.
Capitalized interest on student loans makes payback more expensive
The big question isn’t, “what is capitalized interest on student loans,” but rather, “how does interest capitalization affect your payments?” And, the sad reality is, capitalized interest on student loans can make paying back your balance much more expensive and difficult.
Because capitalization increases your principal balance, you end up paying additional interest on top of interest that you’d already accrued. Your future interest costs will be higher, so your monthly payments and total loan costs will be, as well.
Consider the above example. If you’d made $50 monthly payments on your $10,000 loan while you were in school to avoid capitalized interest on student loans, your total monthly payments after graduation would be $111.02 — assuming a 10-year repayment timeline. The interest paid over the life of the loan would be $5,722.46.
By contrast, by not making payments while your loan was deferred, you’d end up with a $140.16 monthly payment upon graduation. Your total interest costs over time would be $6,819.30.
Because repayment gets so much more expensive, it can be helpful to look into how to avoid capitalized interest on student loans.
How to avoid capitalized interest on student loans
If you want to avoid having your interest capitalized, you’ll need to make payments as your student loan interest accrues. You can make voluntary payments even if your lender does not require you to do so. This is true for both federal and private student loans.
Your payments can be smaller than the ones you’ll owe post-graduation since your goal isn’t to work on paying principal at this time. Instead, it’s to cover interest costs to keep your loan balance from getting bigger.
You’ll need to make these payments before capitalization happens. You can make monthly payments that cover the interest that has currently accrued. Or you can make a lump sum payment to cover the unpaid interest balance before capitalization happens.
You should also max out the amount of Direct Subsidized Loans you take, as interest doesn’t accrue on these loans while you are in school, during your post-graduation grace period, or when you are eligible for deferment after graduating.
When does interest capitalize on student loans?
Figuring out how to avoid capitalized interest on student loans requires you to make payments before the capitalization process occurs. So it’s helpful to know not only what is capitalized interest on student loans, but also when it occurs.
For federal student loans, interest generally capitalizes if your repayment grace period ends on an unsubsidized loan, if you consolidate your federal loans, or if deferment or forbearance end on unsubsidized loans.
Leaving most income-driven payment plans, failing to recertify your income under these plans, or losing eligibility for income-driven plans can also trigger capitalization. And if you’ve chosen the Income-Contingent Repayment plan, interest will capitalize annually.
For private loans, generally, interest capitalizes when your grace period ends after you leave school, or if you’ve put your loans into forbearance and that forbearance ends.
By understanding when capitalization occurs and paying off your interest before that time, you can avoid unnecessary expenses. You won’t end up paying interest on top of interest, and your loans will be more affordable in the long run.