What Is Capitalized Interest on Student Loans?

Understanding how interest works on student loans is important for managing debt. While interest generally accrues on your loan over time, a specific event called capitalization can significantly impact your loan balance. This occurs when unpaid interest is added to your loan’s principal, increasing the total amount on which future interest is calculated.

Understanding Capitalized Interest

Capitalized interest refers to accrued interest that is added to the principal balance of a student loan. This means you begin paying “interest on interest” because the interest rate is then applied to a new, larger principal sum. For instance, if you have a loan of $10,000 and $500 in accrued but unpaid interest capitalizes, your new principal balance becomes $10,500. This higher principal then serves as the base for all future interest calculations. This directly affects the total cost of your loan over its lifetime.

Common Scenarios Leading to Capitalization

Capitalized interest occurs under specific circumstances, often after periods when payments are not required or are paused. These include:

At the end of a grace period, which typically follows graduation or leaving school, if interest on unsubsidized federal or private loans remains unpaid.
At the end of a deferment period, if interest was accruing on the loan during that time.
At the conclusion of a forbearance period, any unpaid interest that accrued will typically capitalize.
Defaulting on a loan, which can trigger interest capitalization.
When consolidating loans, especially federal student loans, any outstanding accrued interest from the original loans is often capitalized into the new consolidation loan.
Under certain income-driven repayment (IDR) plans, if payments do not cover the accrued interest or if a borrower leaves the plan or fails to recertify their income and family size.

Impact on Your Loan Balance and Payments

Capitalized interest has a direct financial impact on borrowers. When accrued interest is added to your principal balance, it inflates the total amount you owe. This increased principal becomes the new starting point for calculating future interest, meaning you will pay interest on a larger sum than you originally borrowed. This leads to a higher total amount of interest paid over the life of the loan. An increased principal balance can also result in higher required minimum monthly payments.

Strategies to Minimize Capitalized Interest

Several proactive steps can help borrowers reduce or avoid the impact of capitalized interest. Implementing these strategies can significantly lower the overall cost of your loan:

Make interest-only payments: Paying even a partial amount during periods when payments are not required (e.g., in-school, grace, deferment, or forbearance) prevents accruing interest from capitalizing. This ensures interest is paid as it accrues rather than being added to the principal.
Understand repayment plans: While income-driven repayment (IDR) plans offer flexibility, some may lead to capitalization if monthly payments do not cover accrued interest or if a borrower no longer qualifies. Carefully evaluate these plans and their specific terms.
Use deferment and forbearance strategically: These options provide temporary payment relief but often result in interest capitalization if interest is not paid during these periods. Use them only when absolutely necessary.
Exercise caution with loan consolidation: Consolidating loans simplifies repayment but often capitalizes all outstanding accrued interest from original loans into the new consolidated loan. Borrowers should weigh this capitalization effect against the benefits of consolidation.
Stay on track with payments and recertify IDR plans: Diligently meeting these requirements prevents capitalization events triggered by default or administrative lapses.