Interest Capitalization: The Hidden Factor Increasing Your Student Loan Balance

If you’ve been making regular student loan payments for a few years, you might be surprised to find your balance growing instead of shrinking. This is often due to a process called interest capitalization.

This hidden factor can increase your monthly payments and overall loan cost, making it more difficult to pay off your student loan debt and achieve your financial goals, leading to stress and uncertainty.

Don’t worry!

In this article, you’ll learn about interest capitalization, its impact on student loans, and strategies to minimize its effects.

Related: How Student Loan Interest Works

Capitalized interest is the unpaid interest added to a loan’s principal balance. When this happens, the interest becomes part of the principal, and the new, higher balance accrues interest. This can substantially increase the total amount owed over the life of the loan.

Interest accrues daily on a student loan’s principal balance from the disbursement date using simple interest. This means interest is charged only on the principal, not any previously accrued interest.

But at specific points, like the end of grace periods, deferments, or forbearances, accrued interest may be capitalized and added to the principal.

This means you’re paying interest on interest, increasing the loan’s principal and the amount of interest that accrues daily, leading to higher student loan payments and larger overall debt.

Capitalized interest is the unpaid interest added to the principal balance, while non-capitalized interest accrues daily but remains separate.

When interest is capitalized, it raises the principal balance, and you pay interest on that increased amount.

In contrast, with non-capitalized interest, you only pay interest on the original principal balance, as it accrues separately.

Illustrating Interest Capitalization: Taylor’s Example

Taylor takes out a $10,000 student loan with a 6% annual interest rate. After graduation, Taylor enters a 6-month grace period before repayment. Interest accrues but isn’t capitalized.

By the end of the grace period, Taylor accrues around $300 in interest. If not paid off before the grace period ends, the interest capitalizes, and the new principal balance becomes $10,300 ($10,000 + $300).

By allowing the interest to capitalize, Taylor pays more interest over the loan’s life, increasing the total repayment amount.

The frequency of interest capitalization depends on the loan type and specific circumstances.

• For federal loans, capitalization typically occurs at the end of a period of deferment or forbearance, when borrowers change repayment plans, or when loans are consolidated.

• For private student loans, capitalization policies can vary by lender, so reviewing your loan agreement is essential.

Interest accrual, capitalization, and compounding are three distinct processes affecting student loans. Let’s briefly clarify each process with examples.

Accrued Interest

Accrued interest is the daily accumulation of interest on a loan’s principal balance using simple interest. It’s charged only on the principal, not any previously accrued interest.

Example: With a $10,000 loan at a 6% annual interest rate, the daily interest accrual is ($10,000 × 0.06) / 365 ≈ $1.64. After 30 days, accrued interest is $1.64 × 30 = $49.20.

Capitalization

Capitalization occurs when unpaid accrued interest is added to the principal balance, increasing the amount on which future interest is calculated.

Example: If the $49.20 accrued interest is capitalized, the new principal balance becomes $10,049.20, and future interest is calculated on this new balance.

Compounding

Some student loans compound interest monthly or yearly, calculating interest on the initial principal and any previously accrued interest.

Example: With a $10,000 loan at a 6% annual interest rate compounding yearly, the first year’s interest is $10,000 × 0.06 = $600. The next year, interest is calculated on the new balance ($10,600 × 0.06) = $636, showing how compound interest grows the loan balance faster than simple interest.

Interest capitalization has several consequences, including an increased overall loan balance, higher monthly payments, and a longer repayment period. These consequences can significantly affect borrowers’ ability to buy a home, get credit cards, qualify for personal loans, and so on.

Increased overall loan balance

When unpaid interest is added to the principal, it results in a larger balance that accrues more interest, leading to higher interest payments over the life of the loan.

Related: What Increases Your Total Student Loan Balance?

Higher monthly payments

The monthly payments will also rise as the principal balance increases due to capitalized interest. This can put an additional financial strain on borrowers, especially if their income hasn’t increased to accommodate the higher payments.

Longer repayment period

With a higher loan balance and potentially higher monthly payments, borrowers may take longer to repay their loans fully. A longer repayment period means more interest will be paid over time, which can significantly increase the total cost of the loan.

Capitalized Interest Consequences: Michele’s Example

• Michele has a $20,000 student loan, a 6% annual interest rate, and a 10-year repayment term.

• After graduation, she struggles with monthly payments, so she requests a 12-month forbearance. During this time, interest continues to accrue daily.

• By the end of the forbearance, Michele accrues around $1,197 in interest.

• If she doesn’t pay this interest before forbearance ends, it’s capitalized, raising her principal balance to $21,197 ($20,000 + $1,197).

• Post-forbearance, Michele switches to an income-driven plan to manage higher payments from capitalized interest.

• This decision extends her repayment period, leading to more interest paid over the loan’s life, further increasing the total interest paid.

Student loan interest typically capitalizes under specific circumstances. Here’s when this happens for federal student loans:

1. End of a grace period. Interest may capitalize when the grace period (usually six months) after graduation or dropping below half-time enrollment ends if any unpaid interest has accrued. Keep in mind that there is no Parent PLUS Loan grace period.

2. End of deferment or forbearance. It may be capitalized if a borrower has unpaid interest at the end of a deferment or forbearance period.

3. Switching repayment plans. When a borrower changes their repayment plan from Revised Pay as You Earn (REPAYE), Pay as You Earn (PAYE), or Income-Based-Repayment (IBR) plan to any other plan, any unpaid interest at the time of the switch may be capitalized.

4. Miss the recertification deadline. If you don’t recertify your income annually for IDR plans, the unpaid interest will be added to your balance.

5. Annually under the ICR Plan. If you’re on the Income-Contingent Repayment plan, it capitalizes yearly. This is how many Parent PLUS Loan borrowers eventually owe a lot more than they originally borrowed.

6. Consolidating federal loans. Upon consolidating federal loans into a Direct Consolidation Loan, any unpaid interest on the original loans will be capitalized and added to the new Direct Loan balance.

The circumstances under which interest capitalizes for private student loans can vary depending on the lender. So reviewing the loan agreement for details on the capitalization policy is essential.

To reduce the impact of interest capitalization on student loans, consider these strategies:

1. Pay interest during grace periods, deferment, or forbearance to prevent principal balance increases.

2. Choose income-driven repayment plans with interest subsidies, like REPAYE, to reduce capitalized interest and loan balance growth.

3. Consolidate loans with a lower weighted-average interest rate to decrease accrued and capitalized interest.

4. Make extra principal payments to reduce interest capitalization and the total loan cost.

5. Refinance with a private lender for lower interest rates, but carefully weigh the loss of federal loan benefits before moving forward.

How to eliminate capitalized interest on student loans

To eliminate capitalized interest on student loans, consider these strategies:

1. Pay accrued interest before capitalization. Make interest-only payments while in school, during grace periods, deferment, or forbearance to prevent principal balance increases.

2. Choose income-driven repayment plans with interest subsidies. Choose plans like REPAYE to reduce interest capitalization and limit loan balance growth.

3. Make extra principal payments. Reduce capitalized interest and total loan cost by paying down the principal.

4. Refinance with a private lender. Lower interest rates through refinancing, but keep in mind that you’ll lose benefits when refinancing federal loans with a private lender.

The Biden administration has introduced new policies and reforms to address the impact of interest capitalization on student loans. These changes focus on limiting interest capitalization under certain circumstances and overhauling the Revised Pay As You Earn (REPAYE) plan to help borrowers.

New policy

President Biden has proposed a regulation to limit interest capitalization, preventing it in several situations, including:

1. When a borrower first enters repayment

2. When a borrower leaves a forbearance

3. When a borrower in the PAYE plan no longer has a partial financial hardship or leaves the plan

4. During periods where a borrower’s monthly payment is less than the amount of monthly interest accrual in certain IDR plans or alternative repayment plans

5. When a borrower defaults

This change, expected this July, could benefit millions of federal student loan borrowers, particularly communities of color disproportionately affected by interest capitalization.

New plan

The Biden administration has also proposed reforms to the REPAYE plan, aiming to lower monthly payments and accelerate student loan forgiveness.

A key benefit of the new REPAYE plan is that interest would no longer accrue in excess of a borrower’s monthly payment, preventing loan balance increases for many borrowers.

Effectively managing student loan debt involves understanding various repayment options and their impact on interest capitalization.

Overview of student loan repayment options

1. Income-driven repayment plans. These plans adjust monthly payments based on income and family size, with options like REPAYE, PAYE, IBR, and ICR. Some plans, like REPAYE, also offer interest subsidies to help reduce interest capitalization.

2. Graduated repayment plan. This plan features lower monthly payments that gradually increase every two years, with payments based on a fixed repayment term.

3. Extended repayment plan. This plan lets borrowers extend their repayment term up to 25 years, resulting in lower monthly payments but increasing the total interest paid.

Pros, Cons, and Impact on Interest Capitalization

Income-driven repayment plans:

• Pros: Lower monthly payments, loan forgiveness after 20-25 years, and interest subsidies for some plans.

• Cons: Longer repayment period, potentially higher total interest paid, and annual income documentation required.

• Impact: Interest subsidies can reduce capitalization and control loan balance growth.

Graduated repayment plan.

• Pros: Lower initial monthly payments suitable for borrowers expecting income growth.

• Cons: Higher total interest paid and potentially higher payments later in the term.

• Impact: Payments first covering less interest may lead to increased capitalization early in repayment.

Extended repayment plan.

• Pros: Lower monthly payments due to an extended repayment term.

• Cons: Higher total interest paid over the loan’s life.

• Impact: An extended repayment term may result in more interest capitalization if payments don’t cover accruing interest.

Tips on Selecting the Best Repayment Plan

1. Evaluate your financial situation. Consider current and future income, expenses, and financial goals to determine the best plan.

2. Consider your loan type. Federal and private loans offer different repayment options. Review your loan agreement and consult your loan servicer to understand your options.

3. Estimate monthly payments and total interest. For an informed decision, use online calculators and tools to estimate your payments and total interest paid under each plan.

4. Reevaluate periodically. Regularly reassess your financial situation and repayment plan, adjusting as needed to ensure it continues to meet your needs.

Managing interest capitalization is vital for borrowers aiming to reduce their loan burden. Apply this knowledge to manage student loans and develop a suitable repayment strategy.

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