What is capitalized interest on student loans?

Capitalized interest is interest that accrues while you’re not making payments. This interest is then added to your loan balance. (Shutterstock)

When you borrow to pay for higher education, your student loan will come with interest — either a fixed or variable rate. If student loan interest accrues and goes unpaid — for example, during a period of deferral — your lender may add it to the principal of your loan.

Let’s take a look at what capitalized interest is and what you should know about it.

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• What is capitalized interest?
• When does interest capitalize on student loans?
• How can you reduce capitalized interest on student loans?
• Can you deduct capitalized interest on student loans?

What is capitalized interest? 

Like most loans, your student loans require you to pay back the amount you borrowed, also known as the principal, as well as interest. But with many student loans, you may not start repayment right away. For example, you may not be required to pay while you’re in school — you may only have to start repaying your loans once you graduate.

But many student loans begin charging interest right away, even if you’re not paying it. When you leave school, this interest is then capitalized, or added onto the principal amount of the loan. This capitalized interest increases your student loan balance and adds to your monthly payment, since you’re paying interest on top of your original interest. 

With some federal student loans, such as Direct Subsidized Loans, the government pays for your interest while you’re in school. But most other student loans include capitalized interest. 

What’s an example of capitalized interest?

Say you borrowed $30,000 for a four-year undergraduate program at a 4% interest rate with a 15-year repayment term. If you don’t make any student loan interest payments while you’re in school, you may have accrued $4,800 in interest over that period. 

When you leave school, that interest is capitalized into your loan — leaving you with a total loan of $34,800 to repay with interest. That means you’ll pay about $40 extra per month than you would otherwise. Because you’re now paying interest on interest, you’ll pay roughly $2,000 more over the life of the loan.

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When does interest capitalize on student loans?

Interest typically capitalizes on student loans before you enter (or re-enter) a repayment period. For federal loans, this can be when your grace period ends after finishing school, when you leave a period of deferment or forbearance, or if you no longer participate in an income-driven repayment plan. But the mechanics vary based on the type of loan you have — federal (Direct Subsidized or Direct Unsubsidized) or private. 

Federal Direct Subsidized Loans

Federal Direct Subsidized Loans are for students with financial need. The federal government pays the interest on your loan when you’re in school, during the grace period after finishing school, and any other time your loan is in a deferment period. That means this interest won’t be capitalized onto your loan. 

But interest can still be capitalized on a Direct Subsidized Loan in certain circumstances. If you go into forbearance — a temporary pause on your student loan payments due to financial difficulty or another circumstance — the interest that accrues during this period will likely be capitalized onto the loan at the end. 

You may also be responsible for capitalized interest if you voluntarily leave an income-driven repayment program (Pay as You Earn, Revised Pay as You Earn, or Income-Based Repayment), if you don’t recertify your income annually, or are repaying your loans under the Pay as You Earn or Income-Based Repayment plans and no longer qualify based on your income. 

Federal Direct Unsubsidized Loans

The government doesn’t pay any interest for you with Direct Unsubsidized Loans, which are available to students regardless of need. Unless you make interest payments while you’re in school, the unpaid interest that accrued will be capitalized into the loan when you begin to repay it. You’ll also be responsible for capitalized interest during other student loan deferments, periods of forbearance, or if you leave an income-driven repayment plan where your payment was less than the interest charges.

Private student loans

Private student loans come from private lenders, and student loan repayment policies vary. In general, many private student lenders allow you to defer payment while you’re in school. As with a Direct Unsubsidized Loan, however, interest will likely begin to accrue immediately after you take out the loan. When you finish school, this accrued interest will typically capitalize onto your principal balance on a private loan. You can make interest-only payments while you’re in school to avoid this.

Talk to your lender about interest capitalization before taking out a private student loan.

How can you reduce capitalized interest on student loans?

You have several options for dealing with capitalized interest on student loans. A few of the more common ways you can reduce these payments — helping you pay off your student loans faster — include:

• Make interest-only payments while in school. The most common time interest capitalizes on a student loan is after you leave school. If you made no payments while attending classes, the interest that accrued during this period is capitalized. But you have the ability to make interest-only payments while in school to keep this from happening.
• Pay the interest before it capitalizes. If making regular payments while in school isn’t an option, you may be able to pay off the interest in a lump sum after graduation and before it capitalizes. You may also be able to make several smaller payments during any grace period between when you leave school and when you begin formal repayment.
• Take out only loans without capitalized interest. You can avoid interest capitalization by only using Direct Subsidized Loans, if you qualify.
• Use an income-based repayment plan. If you have federal loans, you may be able to choose a repayment plan where your monthly payment is based on how much you earn. With some of these plans, even if your payment doesn’t cover the interest, your interest won’t capitalize if you remain in the plan.

Check out Credible to easily compare student loan refinance rates from various lenders.

Can you deduct capitalized interest on student loans?

Yes, you can deduct capitalized interest on your student loans — up to a point. The IRS allows you to deduct $2,500 in interest paid on qualifying student loans each year, or the amount of interest you actually paid (whichever is less). This includes capitalized interest.