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In some periods, such as deferments or forbearance, you do not have to make payments toward your student loan balance. However, interest will still accrue on your loan balance during that period. That accruing interest is known as interest capitalization.
While it is convenient not to need to make payments, it’s worth avoiding interest capitalization if you can. It will add to your balance, and you will have to pay it back throughout your repayment period.
What is capitalized interest on a student loan?
Capitalized interest is unpaid interest that gets added to your loan balance.
When you make monthly payments on a student loan, a portion of your payment goes toward the interest accrued since your last payment. The remainder goes toward paying down the principal balance of the loan.
During deferment and forbearance, interest may still be accruing on your accounts. The main exception is if you have subsidized federal loans. In that case, the government pays your accrued interest while you’re in school and during other types of deferment.
Instead of charging you this unpaid interest once you start making payments, lenders typically add it to your principal balance. This increases how much you owe and how much interest you pay because your interest rate is now applied to a higher balance.
How does interest capitalization work on student loans?
Let’s say you have $35,000 in student loan debt with an interest rate of 5.5 percent and a $379 monthly payment. If you were to request deferment for 12 months, you’d accrue $1,925 in interest during that time.
Once your deferment ends, your student loan servicer will add that amount to your total balance, increasing it to $36,925. With the new balance, your monthly payment would increase to $400 to ensure you can still pay off the debt on your original repayment schedule.
The difference between a $379 monthly payment and a $400 monthly payment over 10 years is $2,520, which is how much that capitalized interest will cost you over the life of your loan.
Interest typically accrues daily, so the longer your deferment goes, the more interest will accrue over time.
How can you avoid student loan interest capitalization?
There are two ways to avoid interest capitalization on your student loans.
The first is to apply for subsidized federal student loans. These loans are designed for undergraduate students with financial needs. Any interest that accrues while you’re in school or during a deferment period will be paid for you if you qualify. Forbearances don’t get the same treatment.
The second option is to make interest-only payments while you’re in college or deferment. This may not be possible if the reason for your deferment is a financial hardship or if you’re not earning an income during school, but it could save you thousands of dollars in the long run if you can afford it.
How can you lower your student loan interest costs?
Student loan interest can make it challenging to keep up with your monthly payments, especially if it gets capitalized after accruing for several months or even years. If you want to reduce the impact of interest on your student loan repayment plan, here are some steps you can take:
- Avoid capitalized interest: Making interest-only payments while you’re in school or during periods of deferment or forbearance can save you hundreds or thousands of dollars on your loan, since it prevents that interest from being added to your total balance.
- Pay more than the minimum: Making extra monthly payments not only shaves off time from your repayment schedule but can also save you money on interest charges. You can add more money to your monthly payment or pay every two or three weeks instead of monthly.
- Refinance your student loans: Depending on your financial situation and your existing student loan terms, you may be able to score a lower interest rate on your loans through a private lender. Many student loan refinance lenders offer low interest rates to people with high credit scores and salaries. Depending on how much you cut your rate, it could save you thousands of dollars.
Can capitalized interest be forgiven?
There’s no student loan forgiveness program designed to directly cancel capitalized interest. However, if you qualify for a program like Public Service Loan Forgiveness, where your full balance is forgiven after you meet the program requirements, your capitalized interest will be included in that discharge.
If you’ve defaulted on federal student loans and enter into a settlement agreement, the agreement may involve waiving some of the interest that’s accrued, but that’s generally interest that has not yet been capitalized and added to your balance.
As a result, it’s best to pursue the other options above to avoid capitalized interest from the start or to tackle your student loan debt in a way that helps you limit your overall interest charges.
The bottom line
Capitalized interest is interest that accrues even if you are not making payments on your student loans. If possible, avoid capitalized interest by making interest-only payments or paying more than the minimum monthly requirement.