How to Avoid Capitalized Interest on Student Loans

Capitalized interest on student loans may not be the next hot topic to debate at your dinner party, but it is a financial concept worth discussing at some point. If you’re one of the 43 million Americans considering or already carrying student loans, you’ll want to understand how student loan interest capitalization affects your payments. Capitalization is a bigger issue than most realize. In 2019 alone, the government capitalized $21.7 billion in unpaid interest on outstanding student loans.

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What is capitalized interest on student loans?

First, it’s important to understand the basic definition of capitalized interest. It’s interest that has been tacked on to the end of your loan balance due to unpaid payments, which means you’re basically paying interest on top of interest.

[Read: Best Student Loans in 2020]

Capitalized interest can affect both federal and private student loans. Capitalization occurs when you aren’t paying your student loan payments and therefore aren’t paying the interest on the loans. Common examples of this are deferment (on unsubsidized loans) and forbearance.

How much does this interest cost?

Interest capitalization will impact how much you pay on your student loans. But how much extra are we talking about?

Let’s assume you borrow $50,000 in federal student loans, at the current interest rate of 6.6%. Then you use a six-month deferment period and the interest begins to capitalize. This results in $1,663 in capitalized interest — in addition to the $18,434 you’re paying in interest over the life of the loan. This affects your monthly payment. For a 10-year repayment plan, your monthly payment is $570.29 per month, but with the added interest from capitalization, it increases to $589.26 monthly.

The bottom line: paying capitalized interest on your student loans means you will pay more for your loan.

Why do interest rates capitalize on student loans?

There are several scenarios where federal loans are subject to capitalization. Private loans are also subject to capitalization, but you’ll need to confirm with the private lender.

1. Deferment. To defer your student loans means you are under a grace period where you pay neither principal nor interest. However, with unsubsidized federal loans, the interest continues to accrue and you have to pay back the interest once the deferment period has ended.
2. Forbearance. Forbearance is when you pause your payments on your federal student loans, no matter what type of loan you have. The interest continues to accrue and you have to pay it back once the forbearance period is complete.
3. Opting out of certain repayment plans. If your federal loans are under the Revised Pay as You Earn (REPAYE), Pay as You Earn (PAYE) or Income-Based Repayment (IBR) plans and you opt-out of these programs, you will have to pay capitalized interest.
4. Income requirements resulting in lower minimum payments. If you are enrolled in certain income-driven repayment plans, your lower income may mean a reduction in monthly payments. If the amount of your monthly payment isn’t enough to cover the total interest on your loans, then the interest will capitalize.

Ways to avoid capitalized interest on student loans

Although the thought of paying interest for several years can be overwhelming, there is a way to reduce or avoid capitalized interest on student loans.

1. Continue making interest payments. If you decide to take advantage of a deferment or forbearance period, you can choose to pay just the interest during the designated time period.
2. Pay off your loans or at least make extra payments. You can pay off your student loans before the end of the term, and this will help you avoid the capitalized interest on your student loans. Or, if you ever have a little extra you can pay towards your loans, then you can save from this too. It’s easier said than done, but you’ll be saving potentially thousands on both capitalized interest and interest over the life of the loan.
3. Refinance. Another way to avoid capitalization altogether is to refinance your student loans. With the competitive rates in the market today, this could be a chance to avoid the capitalization and lower your monthly payments. A word of caution though — by refinancing federal student loans, you automatically remove yourself from eligibility for student loan forgiveness programs, such as the Public Service Loan Forgiveness Program (or PSLF) and income-driven repayment plans. Refinancing can also get trickier if you have less-than-stellar credit, but it’s still worth comparing.
4. Don’t switch repayment plans too often. When you switch from one plan to another, the interest you accrued on one plan will be capitalized on your new repayment plan.

What you should know about consolidating your student loan

Another hot topic among student loans is the idea of consolidating. Not to be confused with refinancing, loan consolidation is when you combine your student loans into one monthly payment. For federal loans, this is referred to as a Direct Consolidation Loan and is administered through the Office of Federal Aid. The interest rate is determined by taking the weighted average of the interest rates from the loans you’re consolidating. This same concept can also apply to private student loans, but you would work with a private lender. You can also choose to consolidate federal loans into a private consolidated loan.

[Related: College Financial Guide: Filling Out the FAFSA]

When you consolidate your federal student loans, any accrued interest from your income-driven repayment plans will be capitalized on your new, Direct Consolidation Loan. This will affect both your monthly payment and how much you pay over the life of your loan.

Too long, didn’t read?

Capitalized interest on student loans adds even more to your debt. It’s essentially interest on top of interest. There are a handful of situations that trigger capitalized interest, such as deferment, forbearance and changing repayment plans. If you can avoid these situations, then you can pay less for your loans. However, if you do find you have to pay capitalized interest, paying off loans early, refinancing or making interest-only payments can save you hundreds, possibly thousands of dollars. Get to know all of your options when it comes to student loans by checking out our student loan refinance guide.

Keep reading

• Best Student Loans in 2020
• Best Student Loan Refinance Companies
• Will Consolidating Student Loans Help Your Credit Score?

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