When Does Interest Capitalize on Student Loans?
Understand the key moments and mechanisms by which student loan interest capitalizes, affecting your principal balance and total cost.
Student loans help millions pursue higher education, but understanding their financial mechanics, particularly interest, is important. A significant aspect of managing student loan debt involves comprehending interest capitalization. This process can increase the total amount repaid over the loan’s life, making it important for borrowers to understand. Knowing when and how interest capitalizes allows borrowers to make informed decisions and potentially reduce their overall debt burden.
Defining Interest Capitalization
Interest capitalization occurs when unpaid interest is added to the principal balance of a student loan. This increases the total amount owed, as future interest is calculated on this higher principal. For example, if a borrower has $10,000 in principal and $500 in unpaid interest, after capitalization, the new principal balance becomes $10,500.
Capitalization can significantly increase the total amount repaid over the loan’s lifetime. Since interest is calculated as a percentage of the principal, a larger principal results in higher daily interest accrual. This can also lead to increased monthly payments once repayment resumes, further impacting a borrower’s financial obligations.
Key Events Leading to Capitalization
Several specific circumstances trigger interest capitalization on student loans. One common event occurs at the end of a grace period for unsubsidized federal loans. Unsubsidized loans begin accruing interest immediately upon disbursement, even while the student is in school or during the grace period following enrollment. If this accrued interest is not paid before the grace period concludes, it is added to the principal balance.
Capitalization also happens at the end of a deferment period for unsubsidized loans. While deferment allows a temporary postponement of payments, interest continues to accrue on unsubsidized loans during this time. If the accrued interest remains unpaid when the deferment ends, it capitalizes, increasing the loan’s principal. Similarly, interest accrues during periods of forbearance for all loan types. While unpaid interest historically capitalized at the end of forbearance, this generally no longer occurs for most federal loan types.
When a loan enters default status, any outstanding unpaid interest often capitalizes. This adds to the existing principal, making the debt even larger and more difficult to manage. Loan consolidation is another event that typically leads to interest capitalization. When a borrower consolidates multiple federal student loans into a new Direct Consolidation Loan, any accrued and unpaid interest from the original loans is added to the principal balance of the new consolidated loan.
Capitalization in Specific Repayment Contexts
Income-Driven Repayment (IDR) plans have distinct rules regarding interest accrual and capitalization. Under some IDR plans, if a borrower’s monthly payment is less than the amount of interest that accrues, unpaid interest can accumulate. This situation, known as negative amortization, can occur when payments are based on a low discretionary income. For certain IDR plans, such as Income-Contingent Repayment (ICR), unpaid interest capitalizes annually.
Capitalization can also occur when a borrower leaves an IDR plan. If a borrower voluntarily exits plans like Pay As You Earn (PAYE), Revised Pay As You Earn (REPAYE), or Income-Based Repayment (IBR), any accrued and unpaid interest may capitalize.
Changing from one IDR plan to another can also trigger capitalization of accrued interest. Failing to recertify income and family size annually for an IDR plan, or no longer qualifying for a reduced payment amount, can also result in interest capitalization. This happens because the loan servicer may then place the borrower into a different repayment structure.