There are two main reasons why your student loans could end up costing more than you originally borrowed. The first is due to interest payments. But the second reason is due to capitalized interest on your student loans.
Unfortunately, there’s not much you can do to avoid accrued interest on your student loans (except for paying them off early). But there are ways to steer clear of capitalized student loan interest.
In this guide, we’ll explain what capitalized interest is and how to avoid capitalized interest on student loans.
What is capitalized interest on a student loan?
Capitalized interest is unpaid interest that has been added to your principal balance.
Why would student loans accumulate unpaid interest? Unpaid interest can accrue anytime you’re paying less interest on your student loans than you would by following the Standard Repayment Plan.
For example, many students defer payment on their student loans until after they graduate. While you may be able to delay payments during school, interest will begin to accrue immediately. With Direct Subsidized student loans, the government will pay the interest while students are in school and for the first six months after they graduate.
But if you have any other kinds of student loans, unpaid interest will capitalize once your repayment begins.
Difference between capitalized and accrued interest
Accrued interest isn’t the same as capitalized interest. To explain the differences between the two, let’s take a look at an example.
Let’s say you go to school for four years and borrow $25,000 at a 5% interest rate. For the sake of example, let’s say that all $100,000 was in either Direct Unsubsidized Loans or private loans.
At the end of year one, your first $25k would add around $1,250 in accrued interest. After year two, your unpaid interest would have grown to over $2,500. And by your graduation, your student loans will have generated around $9,000 of accrued interest.
But here’s the thing: If that $9,000 of accrued interest capitalizes, it will be added to your total loan balance. From that point forward, you’ll pay 5% interest each year on a balance of over $109,000, as opposed to the $100,000 that you originally borrowed.
Once accrued interest capitalizes, you’ll pay interest on your interest for the remainder of your repayment schedule. And over a 10-year repayment period, that would cost you nearly $2,500 in extra interest payments.
When is student loan interest capitalized?
Student loan interest capitalization typically happens at the end of a deferment, forbearance or grace period. Once normal payments begin, any unpaid interest will capitalize.
As mentioned earlier, if you have Direct Subsidized federal student loans, you won’t need to worry about capitalized interest until after you graduate. But if you choose an income-driven repayment (IDR) plan, there are a few situations that could trigger student loan interest capitalization.
- You leave the Revised Pay As You Earn (REPAYE), Pay As You Earn (PAYE) or Income-Based Repayment (IBR) plans.
- You no longer qualify to make income-based payments on PAYE or IBR plans.
- You’re on the Income Contingent Repayment (ICR) plan. On this plan, the interest capitalizes annually.
- You fail to recertify your income for an IDR plan by the income recertification deadline.
Your accrued interest on federal student loans will also capitalize if you consolidate to a Direct Consolidation Loan or refinance your loans.
How to avoid capitalized interest on student loans
If you want to avoid student loan interest capitalization, here are a few ideas:
1. Make interest-only payments while you’re in school
Some private student loan companies, like CommonBond, allow you to make interest-only payments until you graduate. With interest-only student loans, your payment will be much lower during school than the normal principal-plus-interest payment. But at the same time, you’ll avoid capitalized interest on your student loans after you graduate.
If you can afford to pay your student loan interest while you’re in school, this could be a great option.
2. Pay off any unpaid interest before repayment begins
Another way to keep your student loan interest from capitalizing is to pay the loan off in one lump sum before the capitalization period. Since this strategy requires you to pay all the interest off at once, it can be harder for cash-strapped students to manage.
But if you’re able to pay off your accrued interest before your grace period, forbearance or deferment ends, it could save you a lot of money in the long run.
3. Fill out your income recertification form each year
If you’re on an IDR plan, you don’t want to forget to file your income recertification form. Not only will your student loan payments increase, but any unpaid interest will capitalize.
Your student loan servicer is required to notify you about income certification well before the deadline each year. Once you receive your reminder, try to recertify as soon as you can.
4. Change repayment plans only if you’ll save more money overall
While there are a few different IDR plans, you don’t want to switch plans too often. Each time you do, it will trigger your student loan interest to capitalize.
There are times when it may be prudent to switch IDR plans, but make sure you think through the pros and cons. That advice holds true for federal student loan consolidations as well.
Refinancing your federal student loans could be worth it even if doing so causes interest capitalization. That’s because a lower interest rate could save you more money overall — even with a slightly higher loan balance. Plus, when you refinance with a Student Loan Planner® partner, you may be eligible for a $250 to $750 cash bonus.
If you’re looking for more advice on how to avoid capitalized interest on student loans, a Student Loan Planner® consultant would love to help you. Book a consultation today.