Federal Student Loans and Capitalized Interest

Michael Lux Blog, Student Loans 9 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.