How capitalized interest affects your student loans

If you’ve ever wondered how your student loan balance can grow so quickly, consider a hidden culprit — capitalized interest. Student loan borrowers with unpaid interest may have to deal with capitalized interest in certain instances, which increases total loan costs.

Find out how capitalized interest works, what you should know, and how to minimize costs.

What happens when interest capitalizes on student loans?

Student loan borrowers are responsible for paying interest on their principal balance. Interest typically accrues daily, which means things can add up fast. And during certain periods, such as while you’re in school or in deferment, interest can grow even when you’re not obligated to make payments.

Capitalized interest is when that unpaid interest is tacked onto your original loan balance. Now you’re not just paying interest on your principal balance, but paying interest on the unpaid interest that’s been added to it.

This results in a higher loan balance and can increase total interest costs — and even your monthly payments.

Accrued interest vs. capitalized interest

Student loans, like other forms of debt, charge borrowers interest. You get the funds you need and the lender earns interest on your repayment. Interest costs depend on your rate and repayment plan.

Accrued interest refers to the interest that’s added to your account between monthly payments. All borrowers will pay accrued interest. Capitalized interest is taking any unpaid accrued interest on your student loans and adding that sum to your principal balance. This will only be triggered in certain cases.

What does capitalized interest cost?

If interest is capitalized, you’re essentially paying interest on interest. Because of that, it adds to your total costs.

Let’s imagine you have an unsubsidized loan of $40,000 with an interest rate of 5.50%, and you defer payments for one year. That means interest accrues at approximately $6.03 per day, totaling $2,200 over the entire year.

If capitalized, that $2,200 in unpaid interest is added to the $40,000. Now you’re paying interest on $42,200, which can increase your interest costs.

Here is a cost breakdown with a 10-year loan term, looking at the original balance vs. capitalized interest balance. Over the course of your loan, capitalized interest will increase your monthly payment by $24 and your total interest costs by $665.

When does interest capitalize?

When interest capitalizes depends on the type of loans you have. In addition, recent updates mean that interest capitalizes on federal student loans less frequently.

Before July 2023, interest would generally capitalize on most federal loans:

• When beginning student loan repayment
• At the end of a deferment or forbearance
• When entering default
• When switching plans out of select income-driven repayment (IDR) plans
• If you failed to recertify your eligibility for an IDR plan.

However, new rules were implemented on July 1, 2023, scrapping most cases of interest capitalization for federal loans. These rules don’t apply retroactively, but going forward, interest won’t be capitalized in most of the scenarios listed above. Note that interest may still capitalize on federal student loans:

• After a deferment on an unsubsidized loan
• If you leave or no longer qualify for the Income-Based Repayment plan
• If you have unpaid interest and consolidate with a Direct Consolidation Loan

Exceptions to federal capitalization rules

A notable exception to capitalized interest is Direct Subsidized Loans, as the U.S. Department of Education covers the interest costs during school, your grace period, and eligible deferments. Because the government pays the accrued interest, there will be nothing to capitalize when you enter repayment.

Additionally, income-driven repayment plans including Income-Based Repayment (IBR), Pay As You Earn (PAYE), and Saving on a Valuable Education (SAVE) offer some interest subsidies. This means that the government will cover some portion of unpaid interest for a period of time, which can vary by plan and type of loan.

While federal student loans have standardized rules about interest capitalization, private lenders can set their own policies. You can contact your loan servicer for more details, but in general, private student loans may capitalize interest:

• After the grace period
• After deferment ends
• After forbearance ends

How to avoid interest capitalization

Capitalized interest can make student loan repayment even more difficult to manage. To avoid interest capitalization and lower costs, consider the following options:

• Make interest-only payments: If you’re in school or have entered your grace period, you may not be required to make student loan payments just yet. But to avoid potential capitalized interest, you can make interest-only payments.
• Make a lump-sum payment: Use a chunk of cash to make a lump-sum interest payment before any interest capitalizes on your loans.
• Reconsider deferment and forbearance: While deferment and forbearance can be useful short-term solutions, these programs may affect you in the long term. Interest often accrues during these periods, depending on your loans, and will lead to capitalized interest. An income-driven repayment plan is generally preferable and more sustainable if you have federal loans.
• Stay on the Standard Repayment plan: This is the default payment plan loan servicers put federal loan borrowers on when repayment begins. Staying on this plan is typically the most affordable option. Plus, your monthly payments include accrued interest so you can avoid capitalized interest.

Using these strategies, you can avoid capitalized interest and make student loan repayment more manageable.