Compound interest is the idea that your interest earns interest. When an investment or loan generates some type of return or interest, that amount is added to your principal. The new total begins earning interest, compounding the effect as the new amount is once again added to the principal balance.
When it comes to investing, compounding returns can make a big difference in how your portfolio grows over time. It’s one of the most effective ways to build wealth.
Unfortunately, when you talk about compound interest on a loan, the effect is the opposite. This is true of any type of loan — including student loans.
Your student loan is probably one of the biggest offenders, with your interest being capitalized and added to your loan at various points during its term. Let’s take a look at capitalized interest on a student loan and how it impacts you.
1. What is capitalized interest on your student loan? 2.How do you end up with capitalized interest on your student loan? 3. 5 Tips for avoiding capitalized interest on your student loan
What is capitalized interest on your student loan?
When you get a loan, there are two parts:
- Principal. The amount you actually borrowed.
- Interest. The fee you pay for borrowing the money, usually expressed as a percentage of your loan balance.
When you have student loans (or any loan), a portion of your monthly payment goes toward covering the interest charge and the rest goes toward paying down the principal amount. There are times, however, that you might not be paying the full amount of interest.
When this happens, the unpaid interest is capitalized — or added to your principal loan amount.
Because your continued interest rate fees are based on your loan balance, you pay interest on the interest. This can increase your balance over time, especially if you’re on a repayment program that allows you to go long periods of time without paying your full interest cost.
Download the Best Student Loan CalculatorHow do you end up with capitalized interest on your student loan?
Capitalized interest occurs generally after you’ve gone a period of time without making interest payments. That interest accrues and is added to your loan. Here are some of the scenarios that result in capitalized interest on your student loan.
End of your grace period
You’re not required to begin repaying federal student loans until six months after you finish school.
However, if you haven’t been making interest payments while in school and during that grace period, all of that accrued interest is added to your loan principal once you begin repayment.
For example, if you borrow $100,000 and accumulate $10,000 in interest during your time in school and during the grace period, your balance once the grace period ends is $110,000. If you stick with a Standard 10-year repayment plan, you’ll have a payment that’s $100 higher each month — and pay an extra $2,700 over the life of the loan.
Check to see if you have subsidized federal student loans. The government covers the interest for these loans while you’re in school and during your grace period, so you don’t have to worry about interest capitalization.
End of deferment or forbearance
Similarly, if you make use of a deferment or forbearance plan, your interest will occur during this period. Subsidized loans won’t see interest accrual during deferment, but unsubsidized loans do.
Additionally, if you have private student loans and use a hardship plan, your interest will likely accrue and be capitalized at the end of the deferment or forbearance period.
Income-driven repayment
When you can’t make your monthly student loan payment, an income-driven repayment (IDR) plan can help make it more manageable. However, because your payment is so low, you might not be covering your interest costs. Unpaid interest can accrue and be capitalized when you transition off the income-driven repayment plan. Suddenly, your student loan balance is much larger and you could owe even more.
One of the plans, Income-Contingent Repayment (ICR), capitalizes your student loan interest every year that you’re on the plan, and can result in a constantly-growing balance, even if you make regular payments.
Student loan consolidation
When you consolidate your student loans, any unpaid interest is capitalized.
So, if you’ve been on an income-driven plan and then you consolidate, all the accrued interest is added to your total amount.
It’s also important to carefully consider this strategy if you’re hoping for Public Service Loan Forgiveness (PSLF). When you consolidate after being on an income-driven plan, your payments made prior to the consolidation loan won’t count toward PSLF. If you plan to consolidate, it might make sense to do so before getting on income-driven repayment.
5 Tips for avoiding capitalized interest on your student loan
- Pay the interest before it capitalizes: You can choose to make interest payments on your federal loans while you’re in school. It’s usually a small payment, and it can save you money in the long run.
Some private lenders like CommonBond also offer interest-only payments while you’re in school.
- Avoid changing IDR plans: Every time you switch to a different plan, your interest capitalizes. Carefully consider whether it makes sense to change plans. Additionally, check with your servicer to make sure they aren’t changing your plan without your consent. If this happens, challenge the change and have the capitalized student loan interest removed from your balance.
- Certify your IDR plan each year: You’re required to recertify IDR eligibility each year.
If you don’t, your student loan interest will be capitalized as you’re moved to a different repayment plan.
- Consolidate your loans right after graduation: If you know you’ll consolidate your federal student loans, consider doing so right after graduation. That way, you can still get on IDR, and if you’re working toward PSLF, you won’t lose progress later.
- Refinance your student loans: Student loan refinancing won’t stop capitalized interest on your student loans, but a lower rate could save you money. Plus, if you know you won’t qualify for IDR or PSLF and other forgiveness programs, getting on a lower interest and lower monthly payment can help you tackle your student loan debt faster.
A careful plan can help you reduce the amount of capitalized interest you end up with on your student loan. Consider speaking with a Student Loan Planner consultant to help you review your options and create a repayment plan that works for you.
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