What Is Capitalized Interest on a Student Loan?
Updated: Feb 24
Interest capitalization happens when there is unpaid interest added to the student loan's principal amount. Suppose the interest on the federal student loan doesn't get paid as it accrues, such as during periods when a person is responsible for paying that interest. In that case, the lender may choose to capitalize that unpaid interest.
This increases the total amount due on the loan for the life of the loan. Interest is often charged on the higher balance of the principal, and this increases the overall cost for the loan. This happens because the interest is now set on a higher principal amount.
How Is the Capitalized Interest Calculated on Student Loans?
The amount of interest that can accumulate on the loan between monthly payments is determined using a daily interest formula. This requires the multiplying of the outstanding principal balance by current interest rates and then multiplying the result by how many days there have been since the last installment.
Interest rate factors are used to calculate how much interest may accrue on the loan. It's determined by dividing the student loan's interest rate by how many days are in the year.
How it Relates to Interest
Capitalization means that nonpaid interest is added to the loan's principal balance. Therefore, it is possible to borrow less than gets paid back, making the borrower pay much more. This means the person must save up to pay the required amount at various intervals.
Typically, when the borrower makes payments on the student loan, it covers the interest that accumulates between those repayments each month. Therefore, there isn't any unpaid interest.
However, it's possible for unpaid interest to accumulate at times. For example, deferment periods mean that the borrower doesn't have to make repayments each month. If it's an unsubsidized loan, interest accrues during this period, and the borrower is responsible to pay it.
Income-driven repayment plans can also cause accrued nonpaid interest. This happens if the amount of interest accrued is more than the monthly loan repayment required.
If interest on the student loan isn't paid, it is going to accrue during periods where it's required to pay the interest. Lenders have the right to capitalize on that unpaid interest. In turn, that increases the outstanding principal amount that must be paid back for the loan. Since there is a higher balance now, interest is charged on that amount. This increases the total cost of the loan balance. It is best to avoid accrued interest on unsubsidized loans wherever possible, putting an end to the added payments.
How Often Does Interest Capitalization Happen on Federal Student Loans?
While a person is in school, they aren't required to pay on the loan. The money continues to add up, but the total is only the principal, and there's no interest.
However, when that grace period ends, unpaid interest could capitalize. There are other situations where it capitalizes, too. These include during deferment or forbearance periods. This means it's added to the current principal, making that the new price owed, and any new interest is calculated based on that.
Typically, federal student loans through the direct loan program only capitalize interest once, which is at the end of a forbearance or deferment period. However, federal student loans from the FFEL program and any private student loans can capitalize interest at repayment, annually, quarterly, or monthly.
Events Triggering Capitalized Interest
When a person is still within the grace period on their student loans, they don't have to worry about capitalization. These events only happen in specific circumstances. They include:
The grace period ends on the student loans, and repayment is now necessary.
Forbearance periods end, and the monthly installment resumes on the student loan.
The student loan comes out of default, and payment is resumed.
The current repayment plan, such as income-based repayment, is left, or eligibility on the student loans hasn't been recertified.
When student loans are consolidated, this triggers capitalization.
Should Interest Be Paid Off Before It Capitalizes?
Capitalized interest can hurt the borrower because it may raise the student loan. Therefore, it can help to pay off the interest before it capitalizes. Typically, it is possible to save a lot of money by paying the total interest each month, even if no payments are due. It's possible for interest to capitalize at different times, so it's best to make a plan to pay it off at a faster rate.
Generally, the interest rate changes every year, or it can do so. To avoid paying more, it can help to get the money for federal loans. Interest may accrue from the moment the deferment period ends and in other situations. Interest capitalizes based on various factors.
How to Be Rid of Capitalized Interest?
It is no secret how long it takes to get a student loan, but how long does it take to pay off? A person can save a lot of money by paying off their federal loans from school. If no payments are needed because of a deferment or something else, it may be best to make payments each month to keep capitalization low. If a person chooses not to do this, accrued interest is capitalized at the end of the deferment period.
Certain steps can be taken to avoid having to pay capitalization amounts.
Pay in School
It is possible to make payments while a person is in school. Accrued interest starts from the moment a person begins school unless they only have subsidized loans. Pay off the interest while in school to lower the interest rate and make it easier.
Make Interest Payments During Deferment
If a person goes back to school or has a financial hardship, it's possible to pause the monthly installment for a time. This usually only happens for a federal student loan, but private student loans may also have this option. Even if a person has this period to wait on payments, interest grows at the same rate. If it isn't paid, it gets capitalized once the period of deferment is over. It can help to make interest-only payments here to prevent debt from growing during the life of the loan and at the end of the forbearance.
Avoid Changing the Plan
Try not to change the repayment program frequently because this can add capitalized interest to the student loans. There are various plans available, such as an income-contingent repayment plan, graduated repayment, pay-as-you-earn, and the 10-year plan. Once the grace period ends after a person finishes school, capitalized interest can happen. The interest rate on student loans is based on the rates for the year after the grace period ends.
Keep Track of Paperwork
Student loans typically adjust the monthly payment based on the person's income. Therefore, a person is only eligible for such a plan if the adjusted payment is less than what a person might pay on a standard 10-year program offering fixed payments.
Because of that, eligibility must be recertified each year. If the borrower forgets this step, they could be kicked off the program, which means the price a person pays increases, and interest can be capitalized. It can help to use an online calendar to avoid missing this date.
Make Extra Payments
It's not always possible to find extra money that can be thrown on the student loans. However, whenever it is a possibility, do so. This helps to pay both the principal and interest much faster. As the principal is cut down, the loan becomes smaller, so it accumulates less interest. Overall, this helps to speed up the repayment process.
A person is not going to get penalized by making extra payments, regardless of when they occur. Therefore, it's best to call the loan servicer. That way, the extra payment is applied correctly.
Refinance for Lower Interest Rates
It is possible to refinance the student loan to restructure debt. Typically, it's best to choose options with lower interest rates for the loan. In a sense, one or more of the loans are given to a private lender, and they issue you a single loan in its place.
However, there are factors that come into play. For example, the borrower's and their cosigner's income and credit could end up costing them more. Who knows how long it could take to get late student loan payments off of your credit report. However, if it's possible to lower the rates, the person pays less interest with time and can keep the same loan terms as the original loan. This can help with payback concerns and remove it from the record faster.
Sometimes, capitalization happens with a refinance, but even if it does, there's less interest to deal with than if the borrower stayed with the higher rates. That said, when refinancing, the borrower also loses access to certain protections from the federal government. If the person relies on specific situations or loan forgiveness options, this might not be the best move possible.
Capitalization on interest is a real possibility, but it doesn't have to disrupt the flow of repayment. In fact, it's possible to avoid it most of the time with a few pointers. Those who do have to deal with it might want to work on ways to stop it from happening again. Understanding how student loans work and what capitalization means is the first step. Working with Pittsburgh financial planners could also be beneficial to your student loan strategy.