When you borrow money for school, you almost always end up having to pay back more than the initial amount lent to you. Thus, you should always make every effort to find grants and scholarships and other ways to fund your education before resorting to student loans.
Education is expensive, and it is a rare student who can make it through college without borrowing. Luckily, the U.S. Department of Education has a federal student loan program that allows students to borrow money with relatively low interest rates and flexible repayment options.
You may already know that you pay interest on loans, but do you know what it means when interest is capitalized? Interest capitalization can result in you paying even more on your debt, so it is important to understand how it works.
Loan Interest Basics
First, let’s start with some basics about loans and interest and how it all works. The amount that you borrow (the amount that is put toward your college expenses) is called the principal.
Sometimes, loans come with origination fees, which might be something on the order of 1% of the principal. These fees are added to the principal and will be the total amount you have to pay back.
If you paid your loan back immediately, the principal and origination fees would be all that you pay. However, lenders usually hope to make a little money off of letting you borrow (or at least cover their expenses and account for inflation), so loans are charged interest.
You will typically be told the annual interest rate associated with the loan. For example, during the 2019-2020 academic year, federal student loans had an interest rate of 4.53%. But since the repayment cycle is monthly, the interest is charged monthly. Each month, such a loan would accrue 4.53/12 = 0.3775% interest.
For example, if the principal amount were $10,000, after one month, the amount owed would be $10,037.75. If you made a payment that month of $100, then $37.75 of that payment would go toward the interest, and the remaining $62.25 would reduce the principal balance to $9,937.75.
Interest Capitalization
Consider the same loan example from the previous section. If you miss a monthly payment (because you couldn’t afford to, forgot, the loan was in deferment, etc.), in some cases, the interest becomes capitalized. This means that it is added to the principal, and that interest also gains interest the following month.
To compare what happens when interest is capitalized versus when it isn’t, consider this same $10,000 principal balance at 4.53% annual interest if no payments are made in a year. The amount owed on the loan at the end of the year would be:
- $10,430 if interest was NOT capitalized
- $10,462.52 if the interest was capitalized monthly
If you made consistent monthly payments that always at least covered the interest, then there would be no difference in how much you owe, whether the interest on that loan is capitalized because the interest would never be there long enough to get added to the principal. When you aren’t making payments, capitalized interest can make your debt grow at an even faster rate.
Whether interest capitalizes depends on the terms of the particular loan. In the following sections, we look at whether interest capitalizes on different types of student loans.
Interest Capitalization on Federal Loans While in School
You are not required to make any payments on your federal student loans while you are in school. However, if you have unsubsidized student loans, you may want to consider paying interest so that it doesn’t capitalize.
Direct Subsidized Loans are loans that the government pays the interest on while you are in school at least half time, during the six-month grace period after you leave school, and during times of deferment. This means you don’t have to worry about loan interest on these loans while you are in school because it is being taken care of for you. When you leave school and enter repayment, there is no interest to capitalize.
However, if you have Direct Unsubsidized Loans, these loans accrue interest while you are in school, during the grace period, and during deferment or forbearance. If the interest is not paid off as it accrues, then when you enter repayment, all of that unpaid interest is capitalized, meaning it is added to the loan principal and will gain additional interest along with the rest of the balance.
The same capitalization rule applies to Parent PLUS and Grad PLUS Loans. But when it comes to Parent PLUS Loans, a request to defer payment until after graduation has to be made, or the loans will enter repayment immediately upon dispersal.
Interest Capitalization During Deferment or Forbearance
Whether interest accrues and is capitalized during periods of deferment or forbearance depends on the type of loan. If you have requested deferment, then interest on any subsidized federal student loans will be paid by the government during this time and will not accrue or capitalize.
If you have an unsubsidized student loan, then interest will continue to accrue during forbearance. You can pay the interest during this period, or, at the end of the deferment period, all accrued interest will capitalize.
If you enter forbearance instead of deferment, then regardless of whether your Direct Loan was subsidized, it will accrue interest. Again, any unpaid interest during this period will be capitalized when you enter repayment again. (Note that if you happen to have a Perkins Loan, the unpaid interest is never capitalized. The federal government ended the Perkins Loan program in 2017.)
For loans in automatic administrative forbearance due to the CARES Act between March 13 and Sept. 30, 2020, no interest will accrue or be capitalized.
If interest accrued during deferment or forbearance becomes capitalized, then your monthly payments are likely to be higher than before you entered deferment or forbearance, so be aware and plan accordingly.
Interest Capitalization During Loan Repayment
How interest is capitalized during repayment depends on your repayment plan and whether you miss a payment. For certain income-driven repayment plans, your required monthly payment amount might be less than the interest that accrues each month. Under many of these plans, that extra interest is paid by the government.
Here is how interest capitalization works for each of the loan repayment plans:
- Standard, Graduated, or Extended Plans: Your regular monthly payments will always cover the interest. If you miss a payment, though, unpaid interest may capitalize, and late fees may be added.
- Revised Pay As You Earn (REPAYE): If your income-based monthly payment does not cover the interest, the government pays the difference. However, if you fail to recertify your income annually, the unpaid interest is then capitalized. Interest may also capitalize if you voluntarily leave the REPAYE program.
- Pay As You Earn (PAYE), Income-Based Repayment (IBR), and Income-Contingent Repayment (ICR): Conditions are similar to those of REPAYE, but if you no longer meet the income requirements for these plans, you will be moved to a Standard Repayment Plan, and unpaid interest might be capitalized.
What it boils down to is that if you always make your required payments and stay on top of updating your information, your interest won’t be capitalized unless unpaid during forbearance or deferment.
Private Student Loans and Capitalization
Loan capitalization policies can vary considerably based on the lender when it comes to private student loans. With many private student loans, you enter repayment immediately upon loan disbursal, although some allow you to wait until after graduation. In all situations, interest begins to accrue immediately.
Interest that is not paid each month usually capitalizes on these loans. How frequently it capitalizes can vary. If you have questions about how interest capitalizes on your private student loans, contact your loan servicer for details.
The More You Know: Student Loans
When it comes to borrowing money for your education, the more you know, the better off you are in the end. At CollegeFinance.com, we want you to help you learn about borrowing, including all associated costs and how repayment works.
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