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When you borrow to pay for your higher education, your student loan bears interest, either at a fixed rate or at a variable rate. If interest on a student loan accrues and isn’t paid — for example, during a deferral period — your lender can add it to your loan principal.
Let’s see what compounded interest is and what you need to know about it.
You can refinance your student loans to potentially get a lower interest rate. Visit Credible for compare student loan refinance rates from various lenders, all in one place.
What is capitalized interest?
Like most loans, your student loans require you to repay the amount you borrowed, also called principal, plus interest. But with many student loans, you may not start paying back right away. For example, you may not have to pay while you study — you may only have to start repaying your loans once you graduate.
But many student loans start charging interest immediately, even if you don’t pay them. When you leave school, this interest is then capitalized or added to the principal amount of the loan. This capitalized interest increases your student loan balance and adds to your monthly payment, since you are paying interest on top of your original interest.
With some federal student loans, such as direct subsidized loans, the government pays your interest while you are in school. But most other student loans include capitalized interest.
What is an example of capitalized interest?
Say you borrowed $30,000 for a four-year undergraduate program at an interest rate of 4% with a repayment term of 15 years. If you don’t pay any interest on your student loan while in school, you may have accrued $4,800 in interest during that time.
When you leave school, this interest is capitalized into your loan, leaving you with a total loan of $34,800 to repay with interest. That means you’ll pay around $40 more per month than you otherwise would. Since you’re now paying interest on interest, you’ll pay about $2,000 more over the life of the loan.
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When does interest capitalize on student loans?
Interest usually capitalizes on student loans before you enter (or re-enter) a repayment period. For federal loans, this can be when your grace period ends after you finish school, when you leave a period of adjournment or opt-out, or if you no longer participate in an income-based repayment plan. But the mechanisms vary depending on the type of loan you have – federal (direct subsidized or direct unsubsidized) or private.
Federal Direct Subsidized Loans
Federal Direct Subsidized Loans are for students in financial need. The federal government pays interest on your loan while you are in school, during the grace period after graduation, and any other time your loan is in deferment. This means that this interest will not be capitalized on your loan.
But interest can still be capitalized on a direct subsidized loan under certain circumstances. If you experience forbearance — a temporary pause in your student loan payments due to financial hardship or some other circumstance — interest accrued during that time will likely be capitalized on the loan at the end.
You may also be liable for accrued interest if you voluntarily leave an income-based repayment program (Pay as You Earn, Revised Pay as You Earn, or Income-Based Repayment), if you do not recertify your income each year, or if you repay your loans under the Pay as You Earn or Income-Based Repayment plans and are no longer eligible based on your income.
Direct Unsubsidized Federal Loans
The government pays no interest for you with Direct Unsubsidized Loans, which are available to students regardless of their needs. Unless you are paying interest while in school, accrued unpaid interest will be capitalized into the loan when you begin to repay it. You will also be responsible for interest accrued during other student loan deferrals, forbearance periods, or if you leave an income-based repayment plan where your payment was less than the interest charge.
Private student loans
Private student loans come from private lenders and student loan repayment policies vary. In general, many private student lenders allow you to defer payment while you are in school. However, as with an unsubsidized direct loan, interest will likely start accruing immediately after the loan is taken out. When you finish your studies, this accrued interest will generally capitalize on the principal balance of a private loan. You can make interest-only payments while you’re in school to avoid this.
Talk to your lender about interest capitalization before taking out a private student loan.
How can you reduce capitalized interest on student loans?
You have several options for managing capitalized interest on student loans. Some of the most common ways to reduce these payments – helping you pay off your student loans faster – include:
- Make interest-only payments while in school. The most common time interest is capitalizing on a student loan after leaving school. If you have not made any payments during your courses, the interest accumulated during this period is capitalized. But you have the option of paying interest only during your studies to prevent this from happening.
- Pay interest before it is capitalized. If making regular payments while in school isn’t an option, you may be able to pay off the interest in a lump sum after you graduate and before it’s capitalized. You may also be able to make several smaller payments during any grace period between when you leave school and when you officially start paying back.
- Only take out capitalized interest-free loans. You can avoid interest capitalization by using only direct subsidized loans, if you qualify.
- Use an income-based repayment plan. If you have federal loans, you may be able to choose a repayment plan where your monthly payment is based on your income. With some of these plans, even if your payment does not cover interest, your interest will not be capitalized if you remain in the plan.
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Can you deduct capitalized interest on student loans?
Yes you can deduct interest capitalized on your student loans – until a certain point. The IRS allows you to deduct $2,500 of interest paid on qualifying student loans each year, or the amount of interest you actually paid (whichever is less). This includes capitalized interest.