Capitalized interest is accrued but unpaid interest that is added to the principal balance of the loan. Not only does this increase the amount of debt, but it leads to compound interest, where interest is charged on the capitalized interest.
Example of Capitalized Interest
Suppose you have $30,000 worth of private student loans with an average interest rate of 6.05% and a 10-year repayment term. Suppose further that the borrower defers repaying the loan during the in-school and grace periods.
If the interest is capitalized once, when the loan enters repayment, it will be a total of $4,688.75. This is based on a 31 month average life of a loan dollar in an in-school or grace period, assuming two equal disbursements per year. If the interest is capitalized monthly, it will be a total of $5,142.88. A third possibility is if the borrower pays the interest as it accrues during the in-school and grace periods.
This chart illustrates the impact of capitalized interest on the total amount repaid. As can be seen, capitalizing the interest once at repayment increases the total cost of the loan by $1,571.96, as compared with paying the interest during the in-school and grace periods. Capitalizing the interest monthly costs even more, an additional $606.38, for a total of $2,178.33 in extra interest.
Example of Capitalized Interest
Interest During In-School and Grace Periods
Capitalized at Repayment
Interest Paid During In-School and Grace Periods
Balance at Start of Repayment
Total Payments During In-School, Grace and Repayment Periods
Amount Paid In Interest
When Does Interest Accrue?
When the interest grows on your student loan depends on the type of loan you have. In order to avoid capitalization, it is important to know when you are responsible for paying the interest.
The U.S. Department of Education pays the interest on subsidized Federal Direct Stafford Loans during the in-school and 6-month grace period, as well as other periods of authorized deferment, such as the economic hardship deferment. The borrower remains responsible for the interest during forbearances.
The U.S. Department of Education does not pay the interest on unsubsidized Federal Direct Stafford Loans, regardless of whether they are in the in-school or grace periods or a deferment or forbearance. The borrower is responsible for the interest that accrues during all of these periods.
With private student loans, interest accrues and is the responsibility of the borrower during the in-school and grace periods, as well as during forbearance periods. (Private student loans do not have deferment periods, although the term “deferment” is used as a synonym for “forbearance.”)
When Is Interest Capitalized?
Accrued but unpaid interest may be capitalized on a student loan at various stages in each loan.
With Federal Direct Loans, interest capitalizes at loan status changes.
- When the loan enters repayment at the end of the grace period
- At the end of a deferment period on unsubsidized loans
- At the end of a forbearance period on subsidized and unsubsidized loans
- When the borrower voluntarily leaves an income-driven repayment plan
- When the borrower is not longer eligible for an income-driven repayment plan due to an increase in income
- When the borrower is in an income-driven repayment plan, but fails to submit the annual paperwork by the deadline
Unpaid interest on a private student loan may be capitalized as frequently as monthly, even during a forbearance. Some lenders capitalize interest at the same frequency as the federal student loans, others do not.
How to Avoid Capitalized Interest
Interest capitalization involves paying interest on interest (compounding) and should be avoided if at all possible.
Payments on most federal student loans are first applied to fees, then to collection charges, then to interest and lastly to principal. Capitalized interest may be avoided by paying at least the new interest that accrues.
- Pay off the interest on unsubsidized federal loans in a lump sum at the end of the grace period or other deferment periods before it is added to the loan balance.
- Pay the interest on unsubsidized federal loans and private loans as it accrues during the in-school and grace periods.
- Pay off the interest on all federal loans at the end of forbearance periods or as it accrues during the forbearance period.
- Pay the interest on private student loans and private parent loans as it accrues during forbearance periods. This is called a partial forbearance.
- Pay at least the interest that accrues and remains unpaid on negatively amortized repayment plans, such as income-driven repayment plans
Some lenders have special programs which allow you to get an interest rate reduction on their private student loans if you agree to make a small fixed monthly payment (e.g., $25 per month per loan) or pay the new interest that accrues during the in-school and grace periods.
Once you enter the repayment phase on your student loans, you want to feel like you are making dent in the principal balance. You also want to start paying back what you originally borrowed. Unfortunately, if the loans have capitalized interest, it may take a few years before the loan payments pay off the capitalized interest that was added to the loan balance.