What is Capitalized Interest on Student Loans?

Understanding how interest accumulates on your student loans is important when planning for the future. This article will help you understand how capitalized interest on student loans works.

You may have come across several terms when looking through your paperwork and wonder exactly what is capitalized interest on a student loan. In a nutshell, it’s unpaid interest on your student loans that’s added to your loan principal once you’re granted some sort of payment relief, change your repayment plans, or leave school. 

Your monthly payment and interest charges may increase once your unpaid interest is capitalized. In other words, your repayment costs may go up — that’s why it’s a smart idea to try and avoid capitalization.

Here, we dive into more detail about how interest capitalization works. 

How Interest Capitalizes Once You’re No Longer in School

You have several options when it comes to federal student loans (private student loans will vary): pay your loans until your grace period ends, or while attending school, make partial payments. 

If you borrow federal direct unsubsidized loans or private student loans, you’ll take out tens of thousands of dollars over the course of a four-year degree. During this time, interest still accrues — you’re not obligated to pay it yet. Once you leave, this interest will then be added to your principal. 

For those who make partial payments, you’ll be able to reduce the amount you pay overall by lowering the interest that accumulates through your college education. The lower the interest you have by the time you graduate, the lower your loan balance will be.

Of course, you’ll ideally want to take out need-based federal subsidized student loans as you won't be charged interest when you’re in school, if you’re approved for deferment, or during your grace period. 

If You’re Approved for Deferment or Forbearance

Once you’ve been approved for either deferment or forbearance, any unpaid interest may still accrue. While either of these sound great — whether you’re going back to school after graduation or you lose your job — both of these options can end up costing you more money. 

For instance, if you defer your payments for two years to complete your masters degree, not including the six month grace period, that’s two and half years that your loan balance will grow. If you’re not making any payments during that time, you’ll have two and a half years’ worth of interest accrued that’ll be added to your loan balance. 

For this reason, avoiding deferment or forbearance if possible is a smart choice. If you qualify, an income-driven repayment plan may help you manage your monthly payments and accumulate less in unpaid interest. 

What Happens Once You’re No Longer on an Income-Driven Repayment Plan

If your monthly payments aren’t enough to cover all your interest payments when you’re on an income-driven repayment plan, the unpaid interest may pile up. This amount may be capitalized if you leave the Pay as You Earn (PAYE), Revised Pay as You Earn (REPAYE), or Income-Based Repayment (IBR) plans. It can also happen when you fail to recertify your income each year, or you no longer qualify for either the IBR or PAYE due to your income. 

Granted, most income-driven repayment plans won’t capitalize your interest. That is, until you qualify for loan forgiveness or you leave the plan. While you may not be paying down your principal, on this plan, this amount won’t grow either, except for income contingent plans. 

You might not have to worry about any capitalized interest if you decide to leave an income driven repayment plan in three years or less. Besides, if your monthly payments are more than enough to cover the interest you owe, you won’t have any unpaid interest added to your loan balance. 

Where it might become an issue is if you’ve been enrolled in an income repayment plan for a longer period of time. This is especially true if you’ve been paying student loans that are more than your annual salary. That’s why it’s important to look over your payment history carefully before you consider leaving an income driven repayment plan. Check with your loan officer to see if you have any unpaid interest, and whether it’ll be added to your loan principal. 

What Happens When You Consolidate Your Loans 

There are several scenarios that can happen when you consolidate your loans. 

You can choose to take advantage of a federal direct consolidation loan to consolidate your federal student loans. If so, the outstanding interest of all the loans you consolidate will be added to your original principal balance. 

Before you decide to consolidate, you’ll want to check to see how much unpaid interest you’ve accumulated while you are either on an income-driven repayment plan, in deferment, during your grace period or forbearance. It could be that you’ll end up paying more in interest due to a higher principal balance compared to if you didn’t consolidate. 

When it comes to refinancing with a private lender, the same scenario can apply. Any unpaid interest that’s accumulated could trigger interest capitalization if you decide to refinance. Again, check to see how much interest you have accumulated before you go ahead with refinancing. 

That being said, it might still be worth it, especially if you can refinance to a significantly lower rate. Even with a larger principal, you may pay less overall. Or, if you don’t have any unpaid interest, refinancing can help you save even more money. Using a service like Juno to see what your refinancing options are can help you save thousands of dollars — if not more — in interest. 

Strategies to Avoid Capitalized Interest

Ideally, you’ll want to avoid capitalized interest, but it’s not always possible. The point of not making any student loan payments is so that you can focus on your studies and to offer you a period of time to transition out of college life so you can find suitable employment.

If you have the time and financial resources to avoid capitalized interest, you can make partial payments while you’re still in college. You can choose to pay a portion of your interest, or all of it that accumulates so that you’re not faced with a much larger principal amount once you’re out of school. 

You can also pay off an unpaid interest before you face an event that could trigger capitalization of interest, such as leaving an income driven repayment plan. This will prevent it from being added to your loan balance. One last idea is to avoid deferment or forbearance if you can. 

Now that you understand what capitalized interest on student loans are, you’ll use this knowledge to your advantage. Here’s to paying as little as possible for your student loans. 

If you’re someone who wants to save money on student loan interest, there are also other options available. Those who have good credit may be able to qualify for a lower interest rate by refinancing to private student loans. Consider using Juno to check what rates may be available to use — there’s no obligation to sign up for a new loan, and your credit score won’t be affected. 

Sarah Li Cain
Written By
Sarah Li Cain

Sarah Li Cain is a finance writer and a candidate for the Accredited Financial Counselor designation whose work has appeared in places like Bankrate, Business Insider, Financial Planning Association, Investopedia, Kiplinger, and Redbook. She’s the host of Beyond The Dollar, where she and her guests have deep and honest conversations about money affects their well-being.

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