Capitalized interest is one of the hidden dangers of federal student loans.
It is also a source of confusion for many borrowers.
This confusion is a significant 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 – Why Capitalized Interest Matters
Student loans generate interest daily. However, that interest isn’t added to your principal balance immediately. When you make a payment, the accrued daily interest is paid first. Then the remainder of the payment reduces your principal balance.
If you are on an income-driven repayment plan, such as IBR or PAYE, the monthly interest on your student loans may be 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 while principal balance doesn’t move.
Interest is “capitalized” when it is added to your principal balance. This is a significant event because you are now paying interest on a larger balance. This accounting shift can end up costing a borrower a ton of money.
An Example of the Risk of Growing Loan Balances
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 five years of this, an event triggers interest capitalization of the federal loans. The $5,000 of unpaid interest from each of the previous five years gets added to the 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). In short, the cost of capitalized interest in this example is $2,000 per year.
Avoiding Federal Student Loan Interest Capitalization
Given how expensive interest capitalization can be, preventing these events is an important goal. Many of these events are unavoidable. 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 your paperwork for your yearly income certification. Missing a deadline means the borrower is placed back on the standard repayment plan. This change in repayment triggers interest capitalization. Don’t miss an income-certification deadline!
Similarly, if you meet all of your deadlines but your loan servicer makes an error, do not allow them just to 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 the end of the forbearance means interest capitalization. Depending upon how much interest has accumulated and how long it has been since your last capitalized, this lender error could be costly.
An Essential Reminder for Borrowers with Large Federal Balances
A critical concept in student loan literacy is the 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.