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Understanding Capitalized Interest and Its Impact on Student Loans

Student loan interest can start accruing even before you begin making payments. For instance, interest can accumulate while you’re still in school and during your grace period. Depending on your loan type, this interest may be added to your original loan balance when these periods end. This amount, known as capitalized interest, can increase the total amount you pay over the life of your student loan. Let’s delve into how it works and, most importantly, how to avoid it.

How Does Capitalized Interest Work?

Student loans start accruing interest as soon as you receive your funds. If you take out student loans early in college, interest could be accumulating in the background for years. Most student loans offer a six-month grace period, so you don’t have to start making payments immediately after graduating. When the grace period ends, any unpaid interest is capitalized, or added to the amount you originally borrowed. Future interest is then calculated based on this higher amount. It’s also important to note that interest can accrue during periods of deferment or forbearance, or if you’re enrolled in an income-driven repayment plan.

Capitalized interest increases your borrowing costs and can result in a larger monthly payment. The way it works can vary depending on the loan type, including subsidized and unsubsidized student loans, as well as private student loans.

Federal Subsidized Student Loans

Federal subsidized loans are designed for undergraduate students with financial need. The federal government will pay any interest that accrues:

• While you’re enrolled in school at least half-time
• During the six-month grace period
• During deferment periods

In these cases, the interest on your subsidized student loans does not capitalize. However, the borrower is responsible for interest that accrues during forbearance periods, so interest can capitalize once the forbearance period ends if it wasn’t paid.

Federal Unsubsidized Student Loans

Both students and parents can take out federal unsubsidized loans to pay for college. Unlike subsidized loans, the borrower is responsible for any interest that accrues—even if they are in school or their loans are in deferment, forbearance, or a grace period. If the borrower doesn’t pay the interest on their loans during these periods, it will be capitalized.

Private Loans

Private student loans are available through financial institutions, not the federal government. Each lender will have its own rules regarding capitalized interest. Like unsubsidized student loans, interest generally accrues at all times. It’s the borrower’s responsibility to pay any interest that adds up during the life of the loan.

How Does Capitalized Interest Affect My Student Loan Payments?

Capitalized interest increases the total amount you have to repay on your student loans. As a result, your monthly payments may be larger than you originally expected.

How Much Does Capitalized Interest Cost?

Let’s say you borrow a total of $20,000 and your interest rate is fixed at 5.50%. You’d accumulate roughly $91.60 in interest each month. If you’re in college for four years, that works out to 48 months. Now let’s add another six months for your grace period, bringing you to 54 months—and $4,946 in interest. After it capitalizes, your new loan balance will be $24,946, and the interest going forward will be calculated based on this new loan total.

How to Reduce or Avoid Capitalized Interest

Here are some strategies to reduce or avoid capitalized interest:

Make Interest-Only Payments

If interest is accruing while you’re in school, you can make interest-only payments to stay ahead of capitalization. The same goes for your grace period and periods of deferment or forbearance. If you can’t afford to pay all of the monthly interest, paying a lesser amount can still reduce how much is capitalized later on.

Avoid Deferment and Forbearance

These options allow you to temporarily reduce or pause your student loan payments. That can be a lifesaver if you land on financial hard times, but interest might continue adding up. Avoiding deferment and forbearance is ideal. If that’s not possible, try to make interest-only payments while in a period of deferment or forbearance to help cushion the blow.

Pay Off Your Student Loans Faster

If unpaid interest has already been capitalized and you’re in repayment, it’s still possible to save money. Paying off your student loans faster will mean paying interest over fewer months. Just be sure to let your loan servicer know to apply any extra money to the current month’s payment. Otherwise, it might count as an early payment for the following month.

The Bottom Line

Capitalized interest can translate to a higher loan balance and larger monthly payment, but there are ways to sidestep it—or at least reduce the impact. Making interest-only payments while in school and during your grace period can go a long way. This is where having a strong budget comes into play. Prioritizing your credit health is just as important. Free credit monitoring with Experian can help make it a little easier.

For any mortgage-related needs, feel free to call O1ne Mortgage at 213-732-3074. We’re here to help you navigate your financial journey with confidence.

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