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 can 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!
New Rules Help Borrowers Avoid Capitalized Interest Charges
When the Department of Education announced the new SAVE plan, they also announced some changes to help borrowers avoid capitalized interest charges.
First, the Department of Education will only capitalize interest when required by statute. This is good news, but it is also potentially confusing. Interest will capitalize if you switch from the IDR plan because it is required by statute. However, it isn’t required when switching from REPAYE, so interest won’t capitalize in that situation.
Second, the REPAYE/SAVE subsidy now covers 100% of the monthly unpaid interest. Borrowers on this plan won’t have unpaid interest accumulating, so they won’t have extra unpaid interest that could capitalize.
Third, thanks to some new legislation, the Department of Education can now get permission from borrowers to automatically pull IRS records each year. Borrowers who authorize the automatic process will be able to ensure income certification deadlines are met.
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.
Hi Michael,
My wife’s student loans got approved on the SAVE plan in October with 0$ payments. Next year when we recertify our annual income, our combined income/tax filing status will push our payments on SAVE way above the Standard plans cost, so we are hoping to downgrade to the Standard 10 yr Repayment before then, and enjoy this first year of no payments. Do you know if switching from the SAVE plan to the Standard Plan will capitalize all the waived interest that occured in the first year on SAVE?
One of the great parts of the SAVE subsidy is that it will fully cover your wife’s interest while she makes zero dollar payments.
In other words, there won’t be any interest charges to capitalize if she changes repayment plans. Her balance will be the same as what it was when she started on SAVE.
I have federal loan of 26,000 and I just put it in a Income driven plan. I got approved for $0 amount. I also now work part time for research at a college that is in the public sector. I’m confused about the interest now how does that work?
It really depends on the repayment plan you select. The new SAVE plan is probably the best bet for your situation. This is because of the subsidy that will cover your interest.
Why is it that nobody mentions HOW OFTEN is the interest capitalized on student loans. Is it annually, semiannually, or something else? I hope it is not left to the discretion of the loan servicer as it appears with navient.
Because I have already paid $20,300 on a principal amount of $17,796.69 @ 8.25% in 35 months by making one payment of $3300 and 34 payments of $500.00.
And navient is telling me I now have a principal of nearly$8,000
This cannot possibly be correct
It only capitalizes when there is an event that triggers capitalization. You could go for years without the interest capitalizing, but if you change plans for example, the interest would capitalize.
Does moving from one income based plan to another (IBR to REPAYE or the reverse) trigger capitalization? Thank You, Todd
Hi Todd,
Unfortunately, changing repayment plans is something that will trigger capitalization.
However, moving to Revised PAYE could make it worth it, correct? Given that half of the interest is forgiven at the 20-year forgiveness mark?
You are correct Lindsey. For my student loans, I made the decision to switch to REPAYE knowing that it would cause an interest capitalization because it was worth it for me.
The one clarification I’d add is that the interest subsidy kicks in each month, not just at the 20-year forgiveness mark.
I was just told by my loan servicer FedLoan that the admin. forbearance, which causes interests capitalization and is not my fault, cannot be reversed. Anyway to reverse it. This has happened to me multiple times in the past and I didn’t know any better at the time to not let them do it. So now I’m being penalized in a lot more interest every month bc of their mistakes. FedLoan says there’s nothing I can do to get it reversed. Help!?!??
That is definitely an issue.
Have you considered filing a complaint with the Consumer Financial Protection Bureau? Going this route might lead to a positive outcome: https://studentloansherpa.com/file-compliant-student-loan-company/
Michael,
I recently re-certify my enrollment for REPAYE (started application end of 2016 but repayment didn’t start until beginning of 2017) and my new calculated repayment is significantly lower than my initial repayment. I’m guessing this is because my AGI included only 6 months of employment 2016, when I started working summer of 2016. Will this change in repayment cause my interest to be capitalized?
Thanks for your help!
Linh
A change in payment amount does not cause interest to be capitalized… However, a change in repayment plans does. That means if you were on the standard repayment plan and switched to REPAYE, it would be capitalized, but when you certify your income each year for REPAYE, it will not capitalize… assuming you do not miss the deadline.
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
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.
Except that extra interest does matter because it will increase the total amount of the loan, which the payment is calculated from (so payment could go up beyond just the IBR->Standard increase). Right?