Interest capitalization: The hidden student loan cost
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Something may be quietly increasing the total amount you owe on your student loans.
It鈥檚 called interest capitalization, and it鈥檚 rarely talked about. But you could save hundreds of dollars throughout the life of your loan 鈥 thousands, even, depending on how much you owe and your interest rate 鈥 by avoiding it.
Interest capitalization happens when your lender or servicer adds your unpaid interest to your total loan balance. It creates a snowball effect as your new, larger loan balance accrues more interest. Essentially, you end up paying interest on your interest.听Understanding what interest capitalization is and when it occurs can help you dodge it, saving you some cash. Here鈥檚 what you need to know.
When interest capitalization comes knocking
Capitalization typically occurs whenever unpaid interest accrues on your private or federal student loans. There are five specific instances when this might happen for federal loans:
- At the end of your grace period if you have unsubsidized loans. (Subsidized loans and federal Perkins loans don鈥檛 accrue interest while the borrower is a student, so capitalization isn鈥檛 an issue for those borrowers.)
- At the end of a deferment period if you have unsubsidized loans, and at the end of a forbearance for all types of federal loans.
- When you leave an income-driven plan or if you forget to submit updated information about your income and family size each year. You must update that information annually to remain on an income-driven plan.
- When you consolidate your loans and any of the loans you consolidate have unpaid interest.
- If you default on your loan.
Private lenders each have slightly different rules for how they capitalize interest. Generally for private student loans, capitalization happens at the end of your grace period and after a deferment or forbearance, just like with federal student loans. But read your promissory note and check with your lender to find out exactly when your private student loan interest could be capitalized.
How to keep capitalization at bay
There鈥檚 a simple way to avoid capitalized interest: Pay off your accrued interest before it capitalizes, either monthly as it accrues or in one lump sum. For recent graduates, that means paying down the interest that accrued while you were in school before you start repaying your loans this fall.
Here鈥檚 an example. Say you鈥檙e a 2016 undergraduate, dependent student who graduated in four years. You borrowed the maximum amount of unsubsidized federal student loans each year, totaling $27,000 over four years. We鈥檝e mapped out this example in the table below.
Example: 2016 undergraduate who graduated in four consecutive years and borrowed the maximum amount of unsubsidized federal student loans each year.
Loan | Year | Interest rate* | Accrued interest |
---|---|---|---|
$5,500 | 2012-13 | 6.80% | $1,496 |
$6,500 | 2013-14 | 3.86% | $753 |
$7,500 | 2014-15 | 4.66% | $699 |
$7,500 | 2015-16 | 4.29% | $322 |
*Interest rates based on听听set by Congress for the specified years.
As the next table shows, if you don鈥檛 pay off your accrued $3,270 in interest and instead let it capitalize at the end of your six-month grace period, you will pay nearly $1,000 more throughout the standard 10-year repayment period.
Example: The cost over a 10-year repayment period of letting interest capitalize versus paying the interest off at the end of a six-month grace period.
听 | Pay off interest before grace period ends | Don鈥檛 pay off any interest; let interest capitalize |
---|---|---|
Total principal at repayment | $27,000 | $30,269 |
Total paid before repayment begins | $3,270 | $0 |
Total interest paid during 10-year repayment period | $7,074 | $8,052 |
Total payment throughout the life of the loan | $37,344 | $38,321 |
Total savings | $977 | $0 |
But not all college students and new grads can afford to make interest payments before their grace period kicks in.
鈥淚f you are truly borrowing only what you need, you may not be in a position to pay off interest before it capitalizes,鈥 says Heather Jarvis, a lawyer who specializes in student loans.
Even if you can鈥檛 afford to pay the interest in a lump sum, you can make smaller payments while in school to limit the amount of interest that might capitalize when your repayment period begins. Making payments during college 鈥 however small 鈥 can help you form good repayment habits, Jarvis says.
Check with your lender or servicer to find out exactly how much interest you owe and when it will be capitalized. Once capitalization happens, there鈥檚 no going back 鈥 the capitalized interest will start to accrue more interest.
Teddy Nykiel is a staff writer at NerdWallet, a personal finance website. Email:听teddy@nerdwallet.com. Twitter:听. NerdWallet data associate Victoria Simons contributed to this report.
This article was written by and was originally published by听USA Today College.