What is interest capitalized on a student loan?

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Capitalized interest is unpaid interest that is added to your principal – the amount you actually borrowed – so that you end up paying interest on top of the interest. Unless you have a subsidized loan, interest on your student loan starts billing on the first day your lender disburses your loan.

Many students defer payments while they are in school and for six months after graduation. But during this grace period, interest is usually accrued on your student loan. At the end of your grace period, this unpaid interest is added to the total loan amount. Then interest charges begin to accrue on this new larger total.

This is the “interest on your interest” mentioned above, and it can dramatically increase your borrowing costs. Here are some questions to answer to understand this important question:

How much does capitalized interest cost?

The cost of capitalized interest will vary depending on the amount and terms of your loan. A large loan balance, a high interest rate, and a long deferral period can all increase your capitalized interest costs.

Consider the following example: You borrowed $ 40,000 at an interest rate of 5% over a 10-year repayment period. If you pay no interest for four years of college, your loan will accumulate $ 8,000 in interest.

Assuming interest is capitalized at the start of the repayment, your new balance will be $ 48,000 upon graduation. Over 10 years of repayment, you will pay $ 21,094 in total interest charges.

But what if you made interest payments only while you were in school? Your student loan balance at the end of your studies would be the same as the one you borrowed ($ 40,000).

Over 10 years, you would pay $ 18,911 in interest on your loans. That’s $ 2,183 less than the amount you would pay if you didn’t cover the interest while you were in school.

Plus, your monthly payments on that lower balance would be $ 424. But if all the interest is capitalized, your monthly payments would be $ 85 more at $ 509 per month.

What causes interest to capitalize?

Interest capitalized on student loans occurs in different ways. Usually, interest is capitalized when you exit a grace period, deferral or forbearance, switch to another repayment plan, or take out a direct consolidation loan.

However, the details and terms of interest capitalization differ depending on whether you have a subsidized or unsubsidized loan, whether you are on an income-based repayment plan, or have a federal or private student loan.

Federal subsidized loans

  • Federal direct subsidized loans are available for students with financial need.
  • With a subsidized loan, the government pays the interest while you are in school at least part-time. Therefore, there is no interest capitalized on student loans when you graduate.
  • It also pays your interest during your grace period, which is usually six months after you leave school (except for direct subsidized loans disbursed between July 1, 2012 and July 1, 2014). So here, too, you probably won’t have to worry about capitalized interest.
  • The government will also pay interest accrued during a deferral period (a deferral of loan payments during certain reference periods), also avoiding capitalized interest.
  • During forbearance – another type of deferral of your loans – your loan will accumulate interest, and interest will be capitalized, unless you have a Perkins loan. (Note that no federal student loans accrued interest during the emergency forbearance period put in place in response to the 2020-21 COVID-19 pandemic.)
  • If you consolidate your loans under a direct consolidation loan, any unpaid interest will be capitalized.
  • If you enroll in certain income-based repayment plans (including PAYE, REPAYE and income-based repayment) and then exit the program or no longer qualify, interest may be capitalized. See the Federal Student Aid website for details on the interest capitalization of each plan.

Federal unsubsidized loans

  • Federal unsubsidized loans, including the direct unsubsidized loan, are available regardless of the need.
  • With an unsubsidized loan, interest will accrue during your studies and during the grace period. You are not required to make payments during this period, but if you do not, the interest will be capitalized when your loan goes into repayment.
  • During deferral or forbearance, your loan will accumulate interest which, if not paid, will be capitalized when payments resume.
  • As with subsidized loans, if you consolidate your loans under a direct consolidation loan, any unpaid interest will be capitalized.
  • If you join certain income-based repayment plans (including PAYE, REPAYE and income-based repayment) and then exit the program or no longer qualify, interest may be capitalized.

Private loans

  • Private student loans are available regardless of the need. You or your co-signer must meet a lender’s credit and income requirements to qualify.
  • As with unsubsidized federal loans, interest will generally accrue on private loans while you are in school and during any grace period (not all private lenders offer this). Depending on the lender, you may or may not need to make payments during this period, but if you don’t, the interest will be capitalized at the end of your grace period.
  • Deferral and forbearance are usually not offered with private student loans, but when they are, your loan will often accumulate interest which, if not repaid, will compound at the end of those periods.
  • Private loans do not include access to federal income-based repayment plans.

How to avoid capitalized interest on student loans?

Regardless of what type of loan you have, if you’ve accrued interest by the time you need to start making payments, you have options to avoid capitalized interest on your student loans:

  • Pay full accrued interest when you start making payments after leaving school, after a grace period, or when you come out of deferral or forbearance. Of course, this can be difficult to do, depending on your income, the overall loan amount, and the amount of interest you have to pay back.
  • If you aren’t required to make payments during school or grace period, or for some other reason (such as a deferral), you can still make small payments to cover interest. To do this, you may need to track down your student loan officer and track the amount of interest accrued on your loan. This too can be financially difficult, although it will likely save you money in the long run.
  • Try to limit your student loans to federal subsidized loans. This may or may not be possible, depending on the cost of attending your school and the amount of assistance you are entitled to.
  • Finally, avoid changing your student loan repayment plan more often than necessary, as this could trigger interest capitalization.

To get an idea of ​​the impact that interest payments could have on your loans, use our student loan interest calculator.

Can you deduct capitalized student loan interest?

While capitalized student loan interest can increase your borrowing costs, there’s a silver lining: You can deduct capitalized student loan interest from your taxes.

The student loan interest deduction allows you to deduct up to $ 2,500 of the student loan interest you paid in the last year from your taxable income.

Unlike a tax credit, you will not get this money back; rather, the deduction reduces your amount of taxable income.

As long as you’ve paid student loan interest in the past year, whether it’s capitalized or not, you can claim this deduction on your tax return.

Why is capitalized interest on student loans so important?

When it comes to student loans, capitalized interest can become a huge financial burden if left unchecked. The more that interest is added to the current principal, the more interest you will pay.

If you know you won’t be paying off your student loan for a while, whether it’s because you’re in school or got a deferral, find out if interest is accumulating and have a plan to fix it. with that.

Another strategy to lower your interest costs is to refinance your student loans at a better rate. If you can qualify for a lower interest rate, you could lower your overall borrowing costs. But be careful with refinancing federal loans, as it means you will lose access to federal benefits, such as interest subsidies.

It is important to understand interest capitalization and what it can do on your loans. That way, you’ll know how to handle it when the time comes to start paying off your student loans.

Rebecca Safier and Alli Romano contributed to this report.

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