What Is Interest Capitalization on Student Loans?

Interest capitalization on student loans occurs when unpaid interest is added to your loan’s principal balance. This financial event can significantly affect the total amount repaid over the life of a student loan. Understanding how and when interest capitalizes provides borrowers with insight into their loan balances and potential costs.

Understanding Interest Capitalization

Interest capitalization occurs when any unpaid, accumulated interest is added to the original principal balance of a student loan. When this happens, the loan’s principal balance increases, and all future interest accrues on this new, higher amount. This differs from simple interest accrual, where interest is calculated only on the initial principal balance. Instead, capitalization means interest begins to accrue on the previously accrued and now added interest, creating a compounding effect. For example, if a borrower has a $10,000 loan with $500 in accrued but unpaid interest, after capitalization, the loan’s new principal becomes $10,500. Subsequently, the daily interest charges are calculated based on this increased principal, leading to a higher overall cost over time.

Common Scenarios for Interest Capitalization

Several specific situations can trigger interest capitalization on federal student loans:

• When a borrower enters repayment after their grace period ends. For unsubsidized federal loans, interest accrues while a student is in school and during the grace period; if unpaid, it capitalizes when repayment begins.
• When borrowers exit periods of deferment or forbearance. Interest typically continues to accrue during these pauses. For unsubsidized loans, accrued interest capitalizes after deferment, and for all loan types, it capitalizes after forbearance.
• When borrowers change income-driven repayment (IDR) plans, or fail to recertify their income annually for an IDR plan. In some IDR plans, monthly payments might not cover all accruing interest. If a borrower leaves such a plan or does not meet recertification, unpaid interest may capitalize.
• Loan default, which often results from prolonged non-payment where interest continues to accrue.

The Long-Term Financial Impact

Interest capitalization significantly increases the total cost of a student loan over its lifetime. When unpaid interest is added to the principal balance, the borrower begins paying interest on a larger amount than originally borrowed. This means that each subsequent interest calculation will be higher, accelerating the growth of the loan balance. This effect is often referred to as “interest on interest.” A larger principal balance can also lead to higher monthly payments once repayment resumes, or it can extend the overall repayment period. The increased balance can make it more challenging for borrowers to reduce their debt, potentially prolonging their financial obligations.

Strategies to Reduce Capitalized Interest

Borrowers can take several steps to minimize or avoid interest capitalization:

• Make interest-only payments during periods when payments are not required, such as during in-school periods, grace periods, deferment, or forbearance. Even partial interest payments can reduce the amount that ultimately capitalizes.
• Choose a repayment plan that ensures monthly payments cover all accrued interest from the start. This approach ensures the loan balance does not grow due to unpaid interest.
• Understand the terms of income-driven repayment plans. Some IDR plans, like the Saving on a Valuable Education (SAVE) Plan, offer interest subsidies that prevent unpaid interest from capitalizing as long as required payments are made.
• Consider strategic loan consolidation. While consolidation itself can trigger the capitalization of all outstanding interest on the loans being consolidated, it can be part of a broader financial strategy, potentially simplifying payments or allowing access to certain repayment plans that might offer future interest benefits or forgiveness pathways. Borrowers should carefully evaluate how consolidation impacts their specific loan types and accrued interest before proceeding.