Capitalized Interest: How It Affects Your Student Loan Payments

Student loans are hard enough to deal with; you don’t want to have to pay more than you absolutely must. But if you aren’t careful, that’s exactly what can happen thanks to capitalized interest. Over time, your loan principal can grow, forcing you to repay more than you initially borrowed.

By understanding how capitalized interest affects your student loan, you can take steps to stop interest from being added to your loan principal. Here’s what you need to know about capitalized interest and how it affects different types of student loans.

What Is Capitalized Interest?

If you don’t pay the interest as it accrues on your student loans when you’re responsible for interest payments, the interest is capitalized, meaning it’s added to your loan principal. Going forward, interest will be charged on the higher principal amount, increasing how much you’ll pay during your loan repayment term.

How Capitalized Interest Works

With student loans, interest starts to accrue on your loan right away. Interest will continue to accrue until the loan is paid in full. Depending on the type of loan you have, the government may cover some of the interest charges, or you may be solely responsible for the interest payments.

Beyond general interest charges, capitalized interest only occurs in certain circumstances. Typically, interest is capitalized when you choose not to make payments against the interest that accrues during particular stages of your repayment term. For example, interest is capitalized after periods of deferment, where you temporarily postpone making payments.

Capitalized Interest Costs

Capitalized interest is one of the biggest reasons borrowers end up repaying substantially more than they originally borrowed. If you don’t pay interest as it accrues, you’ll pay more in interest charges.

For example, let’s say you had $30,000 in unsubsidized federal student loans at 5% interest and a 10-year repayment term. With that loan term and interest rate, $125 in interest would accrue each month.

If you opted to defer your payments for 12 months, interest would capitalize on your loan and be added to your loan principal at repayment. In this scenario, $1,500—$125 each month for 12 months—would be added to your loan principal. Once you start repaying your loans, you’d have a higher monthly payment because you have a higher loan principal. By the time you repay your loan, you will repay a total of $40,092.76. By deferring your payments, you’ll pay $1,908.76 more than if you stuck with the original repayment schedule thanks to capitalized interest.

Loan Information	Original loan	Capitalized interest after 12-month deferment
Balance	$30,000	$31,500
Repayment term	10 years	10 years
Minimum monthly payment	$318	$334
Total interest paid	$8,184	$10,093
Total amount paid	$38,184	$40,093
Total difference		$1,909

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How Capitalized Interest Is Handled with Different Types of Student Loans

When interest is capitalized is dependent on the type of student loans you have, federal or private, and whether the loans are subsidized.

Federal Student Loans

With federal loans, your loan type and repayment plan affects whether interest is capitalized.

If you have subsidized federal loans, the U.S. Department of Education will cover interest that accrues while you’re in school, during your grace period and during any periods of deferment.

For other loan types, interest is capitalized:

• After periods of deferment or forbearance. If you have unsubsidized loans, interest is capitalized after periods of deferment. If you suspend payments under forbearance, unpaid interest is capitalized on all federal loans.
• Following the grace period on unsubsidized loans. With unsubsidized loans, you have a grace period after graduation where you don’t have to make payments. If you don’t make payments against the interest, the interest will be capitalized at the end of your grace period.

If you enroll in certain income-driven repayment (IDR) plans, you may qualify for an interest rate subsidy. If you’re enrolled in Pay As You Earn (PAYE), income-based repayment (IBR), or Revised Pay As You Earn (REPAYE), the government will pay all or a portion of the remaining accrued interest that is due each month for a fixed period. How long the government covers the interest varies based on your repayment plan.

However, interest can be capitalized with IDR plans in some situations:

• If you are enrolled in PAYE or IBR and are no longer eligible or voluntarily leave the repayment plan, unpaid interest will be capitalized.
• Under REPAYE, unpaid interest will be capitalized if you leave the repayment plan or fail to recertify your income.
• If your monthly payment under an income-contingent repayment (ICR) plan is less than the amount of interest that accrues, unpaid interest will be capitalized annually. If your outstanding loan principal grows by more than 10% of your original loan principal when you entered into repayment, interest will stop being capitalized. However, interest will continue to accrue.

Private Student Loans

With private student loans, there is no government subsidy; you are completely responsible for paying all interest that accrues.

Interest starts accruing the day your loan is disbursed. If you defer payments until after graduation, interest will be capitalized once you enter repayment. Interest also will capitalize after periods of deferment or forbearance.

This can be a particularly significant issue if you choose to go back to school for a graduate or professional degree. Many private student loan lenders will allow you to defer your payments while you’re in graduate school, but interest will continue to accrue. At the end of your deferment—once you finish your master’s degree, for example—unpaid interest is capitalized. By deferring your payments to get your next degree, you could end up paying thousands more than you originally borrowed.

5 Ways to Avoid Capitalized Interest

Since capitalized interest can have such a costly impact, you should try to avoid it as much as possible. To prevent interest from being capitalized, follow these five tips:

• Make interest-only payments while in school. With private loans, you can often defer making any payments until after graduation. However, it’s a good idea to make payments each month against the interest that accrues while you’re in school to prevent it from being capitalized.
• Pay the interest during your grace period. While payments aren’t typically required during your grace period for private loans or unsubsidized federal loans, making payments that cover the accrued interest will stop interest from being capitalized.
• Use lump sums to chip away at interest during deferments. If you defer your payments, consider using windfalls—such as your tax refund—to pay off interest that accrues. By doing so, interest won’t be capitalized at the end of your deferment.
• Stick to a standard repayment plan. If possible, stay on a 10-year repayment plan rather than entering into an alternative payment plan or IDR plan. With a standard repayment plan, your payment will be enough to cover accrued interest and a portion of the principal, so no interest is capitalized.
• Recertify your income. If you’re on an IDR plan, make sure you recertify your income and family size each year by the annual deadline. Otherwise, you’ll be removed from the plan, and interest might be capitalized, causing your loan principal to grow.