Understanding Capitalized Interest on Student Loans

Paying for college can be a daunting task, and understanding student loan interest is a critical part of the process. Student loan interest is essentially the cost of borrowing money. When you borrow money, you agree to pay back the original amount (the principal) plus an additional amount (the interest). This article will explore what capitalized interest is, how it works, and how you can avoid it.

The Basics of Student Loan Interest

At its core, student loan interest is the cost of borrowing money. Think of it like this: You borrow $1,000 from a friend and promise to pay them back $1,100 by the end of the year. The extra $100 is the interest.

An interest rate is the percentage of the principal charged by the lender when you borrow money. A lower interest rate is better, as it means you’ll need to repay less money than if you had a higher interest rate. But even with a low interest rate, most borrowers will still end up paying back more money than they originally borrowed.

When you start making payments, your loan servicer usually applies your payment to interest first, then to principal. That’s why it’s so important to understand the difference between student loan interest versus principal.

What is Capitalized Interest?

Capitalized interest is unpaid interest that’s added to the principal balance of your loan. Capitalized interest is the addition of unpaid interest charges to a loan balance. Most people are introduced to capitalized interest when discussing student loans or certain mortgages.

Suppose you’ve borrowed money from a lender. You get charged interest on the outstanding principal balance over time, say, monthly. But even if you’re not making payments, the interest charges may still build up. In some cases, that accumulated accrued interest gets added to your principal balance, a process called capitalizing the interest.

Interest may accrue on student loans during the duration of the loan and even during the grace period. When this happens, interest is calculated and added to the balance, meaning that it can add up quickly over time.

How Capitalization Works

Interest accrues daily, but it’s typically added to your loan balance monthly. This is where things can get tricky. Interest capitalization happens after a period of non-payment on a student loan. These non-payment periods include grace periods, forbearance, or deferment.

During these periods, the interest is still accruing on your loan even though you are not making loan payments. Once these periods end, the interest capitalizes, which means it is added to your principal loan balance. From then on, your interest is calculated based on that new, larger principal amount.

For example, say you borrow a $10,000 student loan with an interest rate of 6.8%. The amount of interest that accrues per day is $1.86. If you defer your loan for six months and you do not pay off the interest as it accrues, the loan will accrue $340 in interest. When you end deferment, the accrued interest of $340 will capitalize, meaning your principal balance will now be $10,340. This will cause the amount of interest that accrues per day to increase to $1.93.

Capitalized Interest in Different Loan Types

Student Loans

As soon as you get the borrowed money to pay for education expenses, it begins accruing interest. But loan repayment doesn’t always begin while you are in school - making prime ground for capitalized interest. In fact, there may even be a grace period after you finish school that allows you to further delay starting to make payments. Some of the same student loan features that add financial flexibility for students/parents can end up costing extra money in the end, because of capitalized interest. Similarly, a general forbearance, which pauses loan payments if you’re having financial difficulties, almost always results in capitalized interest.

Negative Amortization Loans

In a negative amortization loan, the payments are too small to cover the normal interest charges and principal payments that would be required to pay off the loan over time. For example, if you have a negative amortizing mortgage, as time goes by and even though you make payments, your loan balance keeps increasing because the unpaid interest charges are capitalized each month.

Strategies to Avoid Interest Capitalization

So what can you do to avoid interest capitalization? Here are several strategies:

Pay Interest During Non-Payment Periods: You can pay the interest on your loans while you are in school or during forbearance or deferment periods. Your loan servicer can help you if you are unsure how to do that.
Make Interest-Only Payments: Another option is to make interest-only payments on your student loan during any period that your loan is accruing interest, like when you are in school.

Read also: Capitalization in Special Education Writing
Make Payments During the Grace Period: It’s a good idea to make payments on your student loan during the grace period, or at least pay enough to cover the monthly interest that accrues. By knowing the date on which that capitalized interest will be added to your principal balance, you can take steps to avoid these additional costs.
Make interest-only payments while in school: Even $10-$20 a month can keep interest from building up.
Set up automatic payments: Some federal loan servicers offer a 0.25% interest rate discount if you enroll in autopay.
Refinance later (if it makes sense): Once you graduate and build credit, refinancing could help you secure a lower interest rate.

Federal Student Loan Interest vs. Private Student Loan Interest

It's vital to differentiate between federal and private student loans, as their interest accrual and capitalization rules can vary significantly. Federal student loans often have more flexible repayment options, including income-driven repayment plans, which can affect how and when interest capitalizes. Private student loans, on the other hand, may have fewer options for avoiding capitalization, making proactive management even more important.

The Impact of Capitalized Interest

When thinking about personal loans, capitalized interest has the potential to cost you more money in the end. The most immediate impact is a higher loan balance. With a larger principal, you'll accrue more interest daily, leading to higher monthly payments and a greater total repayment amount over the life of the loan.

Understanding Loan Servicers

Your loan servicer is the company that handles the billing and other services for your federal student loan. It is essential to maintain open communication with your loan servicer to understand your loan terms, interest rates, and any periods of deferment or forbearance that may lead to capitalization.

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