Federal Student Loans and Capitalized Interest

Michael Lux Blog, Student Loans 4 Comments

When it comes to understanding federal student loans, the subject of capitalized interest is one that most borrowers do not understand.  This is a major problem for two reasons.  First, loan servicers do a horrible job preventing capitalized interest issues and explaining the consequences.  Second, not understanding capitalized interest can cost a borrower thousands of dollars.

The Basics

Student loans generate interest on a daily basis.  However, that interest isn’t immediately added to your principal balance.  When you make a payment, that interest is first paid off and then the remainder of the payment reduces your principal balance.

If you are on an income driven repayment plan, such as IBR or PAYE, it is possible that the monthly interest on your student loans is larger than your monthly payment.  When this happens the interest balance actually grows each month, but your principal balance stays the same.  Similarly, if you are in school or on a deferment or forbearance, interest continues to accumulate, but it is not added to your principal balance.

Interest is “capitalized” when it is added to your principal balance.  This is a significant event because you are now paying interest on the newly capitalized interest.  This accounting shift can end up costing a borrower a ton of money.

An Example

Suppose you have $100,000 in student loans at an 8% interest rate.  Those federal student loans will generate $8,000 per year in interest.  If you are on an income driven repayment plan, and your monthly payments are $250 per month, you are only paying $3,000 per year towards your student loans.  Your balance is growing by $5,000 per year.

If your interest is not capitalized, your loan will continue to generate the same $8,000 of interest each year.  However, suppose after 5 years of this, an event triggers interest capitalization.  That means 5 years times the $5,000 of interest that went unpaid each year, is added to your principal balance.  As a result your principal balance is now $125,000.

The following year, the interest generated by the loan is not $8,000, instead it is $10,000 (this number is the $125,000 times the 8% interest).  That means the interest capitalization is costing you $2,000 per year.

Avoiding Interest Capitalization

Given how expensive interest capitalization can be, preventing these events is obviously an important goal.  Many of these events cannot be avoided.  However, with some planning, expensive triggering events can be eliminated.

The following events trigger interest capitalization:

  • The loan entering repayment at the end of school
  • A loan deferment or forbearance ending
  • Federal direct consolidation
  • A change in repayment plans
  • The loan going into default

Going back to our original example shows the importance of timely submission of you paperwork for your yearly income certification.  If you miss a deadline, you are automatically put back in the standard repayment plan.  This change in repayment triggers interest capitalization.  Don’t miss any deadline!

Similarly, if you meet all of your deadlines but your loan servicer makes an error, do not allow them to just put you on an administrative forbearance while they get things sorted out.  The loan servicer may tell you that you will not be paying any money during the forbearance, but once it ends, the interest is capitalized.  Depending upon how much interest has accumulated and how long it has been since your interest was last capitalized, this lender error could be extremely expensive to you.

Bottom Line

A critical concept in student loan literacy is capitalization of unpaid interest.  If you have a large loan balance and your monthly payment is less than the monthly interest, it is critical to avoid events that trigger capitalization.

 

  • Andrew Lovy

    Hi Michael,

    I am a physician with a significant amount of debt (~350K) and have been enrolled in IBR for the past 6 years while in training and just took a job at a 501c3 institution. My plan is to qualify for PSLF. Once my income increases at the conclusion of my training I assume that I will no longer qualify for IBR and will be switched to a standard 10 repayment plan. Will this count as a qualifying event that will cause my interest to be capitalized?

    I was also considering switching from IBR to PAYE lower my payment now, but as I only have 12 months of training left which will likely spell the end to my qualification for IBR/PAYE I assume this wont make sense as it will trigger a qualifying event.

    Thanks!

    • Andrew,

      I’m a little confused on the circumstances here. Please correct me if I’m wrong on any of the following:
      – You plan on going after PSLF
      – You have not yet started working for an eligible employer, but you soon will
      – Once you start this work, your income will be so large that you will no longer qualify for IBR

      If I can ask, approximately how much do you expect to make once your training ends? I can use this information and write up a “student loan plan” outlining different strategy options you have to eliminate your debt

    • AL

      Sorry about the confusion, Ive been working for 6 years as a resident/fellow at qualifying 501c3 institutions making 6 years of qualifying payments. Ive submitted employer certification forms yearly and all appears to be on track. Later this year when I finish training I will begin working at another qualifying 501c3 institution and hope to have my loans forgiven after another 4 years of qualifying payments. I do not expect to qualify for IBR any longer at that point because of my income but assume I will continue making qualifying payments through a standard 10 year plan. Lets assume $300K a year.

      Thanks for your help, its not easy getting straight answers
      Andrew

    • Andrew,

      That makes sense. Thanks for clarifying.

      To answer your question, the standard repayment plan is eligible for PSLF. My suggestion to you would be to send in a certification form within a couple months of switching to the 10-year plan. That way you can verify that you are still on track and that there were not any issues. If there are, you haven’t wasted a year.

      As far as changing repayment plans, yes, it does cause interest to be capitalized. However, if your balance is ultimately going to be forgiven under PSLF, the extra interest really won’t matter.