Compound interest is one of an investor’s most cherished tools. Interest being added to your principal allows your money to grow at an increasing rate each year. That’s great with investments — but not great when it comes to loans. There are times when interest is added to your student loan principal.
It’s called capitalized student loan interest, and it’s something you’ll want to avoid, unless you like the idea of paying interest on your interest.
Here’s how capitalized student loan interest works, when it can kick in and how to avoid it.
What is capitalized interest on a student loan?
Most loans, including student loans, are made up of two parts — principal and interest. When loans are paid back on a normal schedule, you pay the appropriate amount toward the principal and interest each month.
However, if you’re paying less than what you would on a normal schedule, you’ll accumulate unpaid interest. This unpaid interest is a problem because there are times when it can capitalize.
When this happens, the capitalized interest is added as principal to your loan. After this occurs, your interest charges are based on this new loan balance moving forward. And for the rest of your loan repayment schedule, you’ll literally be paying interest on your interest.
Let’s say you borrow $100,000 in student loans with a 5% interest rate and accumulate $10,000 in interest while you’re in school.
The moment you begin repayment on your loan, all of that unpaid interest could capitalize. You would then owe annual interest on a balance of $110,000 instead of $100,000. On a Standard 10-year repayment plan, that would cause your monthly payment to be over $100 higher and would cost you an extra $2,700 in interest over the life of the loan.
4 scenarios that can capitalize your student loan interest
Below are instances that could trigger a capitalized-interest student loan situation for you.
1. Your grace period ended
Most federal student loans have a grace period while you’re enrolled in school. Some private student loans do as well. Federal student loans typically have a six-month grace period before repayments are due.
While you don’t have to make payments until after your grace period, interest typically still accrues during this time. And once your repayments begin, that interest could capitalize. If your federal loans are subsidized, the interest you accrue during the grace period won’t capitalize. It will, however, with unsubsidized loans.
2. Your deferment or forbearance period ended
If you postpone payments during a deferment or forbearance period, interest can continue to accrue. That interest is added to your student loan principal once repayment begins.
Although all private student loans accrue interest during deferment, not all federal loans do. Unsubsidized federal loans accrue interest during deferment, but subsidized federal student loans don’t.
3. Your status changed with an income-driven repayment plan
Income-driven repayment (IDR) plans can seem like a godsend when you’re just starting your career or are dealing with a low income for any reason. But changes in IDR status are also a common cause of capitalized student loan interest.
For instance, if you leave the Revised Pay as You Earn (REPAYE), Pay as You Earn (PAYE) or Income-Based-Repayment (IBR) plan, the interest your loans accrued while on the repayment plan will capitalize.
Also, if your income increases and you no longer qualify for income-driven repayment under PAYE or IBR, your accrued interest capitalizes.
And borrowers who are on the Income-Contingent Repayment (ICR) plan won’t be happy to hear that if their monthly payment is less than the amount of interest that accrues, any unpaid interest automatically capitalizes annually.
The final way that IDR plans can cause your student loan interest to capitalize is the easiest to avoid. It’s by simply forgetting to annually recertify your income for the REPAYE, PAYE and IBR plans.This mistake can cost borrowers thousands of dollars in added interest over the life of the loan.
4. You consolidated your federal student loans
If you’ve accrued unpaid interest through an IDR plan and you choose to consolidate your federal student loans through the Direct Consolidation Loan program, that unpaid interest will capitalize.
One other thing about Direct Consolidation Loans: Are you working toward a federal student loan forgiveness program, like Public Service Loan Forgiveness (PSLF)? If so, you’ll lose credit for any payments that you made before your consolidation.
How to avoid capitalized student loan interest
Want to avoid capitalized student loan interest? Here are a few strategies you may want to try.
Repay the interest before it capitalizes
Money can be really tight while you’re in school. If you were rolling in dough, you wouldn’t be needing to take out student loans in the first place, right?
However, if you bring in any income whatsoever during your college years, it could be a smart move to pay off the interest on your loans as they accrue. Some private lenders, like CommonBond, even offer interest-only repayment plans to students until they graduate.
Whether you choose to pay off your interest as it accrues or in one lump sum doesn’t matter. The key is that you must pay it off before repayment begins.
Don’t change IDR plans too often
There are situations when changing IDR plans could be a smart move. But keep in mind that the interest you’ve accrued on one plan capitalizes when you switch to another.
Also keep an eye on your student loan servicer. Some have been known to incompetently switch customers from one plan to another when they shouldn’t have.
Has your student loan servicer switched you to a different IDR plan without your consent? If so, you can challenge this. Ask your servicer to fix its mistake and request that the capitalized student loan interest be removed from your loan balance.
Recertify your IDR eligibility each year
This one seems simple, but it’s so important. Don’t allow the recertification period to slip by without sending in your proper income verification.
Simply forgetting to recertify could not only make your payments skyrocket but can cause your unpaid interest to capitalize as well.
Set a reminder on your phone. Do whatever you need to do to make sure that you don’t forget to get this done each year — and well before the deadline. It could save you a ton of money.
Consider refinancing your student loans
While refinancing may not be able to keep your student loan interest from capitalizing, moving to a loan with a lower interest rate could still save you money overall.
Keep in mind that if you refinance from a federal loan to a private loan, you’ll lose all federal benefits, like access to IDR plans and the possibility of PSLF.
If you still have lingering questions, consider reaching out to a Student Loan Planner consultant to create a custom repayment plan of your own.