What Is Capitalized Interest On My Student Loan

Q: I just received a statement for tax purposes on my private student loans. I am currently in forbearance on the private student loans, and I noticed I had something called “capitalized interest” on my loan statements. What is capitalized interest and why do I have it?

A: If you have read in your student loan terms or have heard your student loan lenders speak about the term “capitalized interest”, you are likely going to want to find out if the lender will capitalize the interest on your student loans, under what terms, and if they do this multiple times throughout the year.

Capitalized interest on student loans can happen for a few reasons, such as using the grace period, deferment, or forbearance options on the student loans. Some student loan lenders will take the interest that accrues on the student loans while you are in college or in a deferment period and then add it to the principal, or the original borrowed amount of the loan (this is capitalization). Usually this only applies to unsubsidized federal student loans and private student loans. What capitalization does, is it increases the amount owed on the principal of the loan, which can increase the monthly payment amount of your student loan after the deferment, forbearance, and/or grace period is over (for private student loans interest will always likely capitalize during deferment or forbearance). Since using a forbearance or deferment can increases the total amount paid on the loan significantly, it is suggested to not utilize these options unless absolutely necessary.

In addition to capitalizing the interest during the deferment, forbearance, and grace periods, there are some student loan lenders out there that will capitalize interest every 3 or 6 months, while others only once a year. For you as the borrower, the least expensive option is going to be a lender that is capitalizing the loan interest only once.

What Is Capitalized Interest?

Capitalized interest refers to the interest that accrues on your student loan and is then added to the principal amount of the loan, increasing your overall loan balance. Once the interest is capitalized, it becomes part of the original loan amount. This can have significant implications on your repayment, as it can increase both the size of your monthly payments and the total amount you will need to repay over time.

How Does Capitalized Interest Happen?

Capitalized interest typically happens during periods when you’re not required to make payments, such as during a grace period, deferment, or forbearance. During these periods, interest still accrues on your loan, but you’re not making payments to cover that interest. If the interest is not paid during these periods, it gets added to the principal amount of your loan, which is called capitalization. The interest continues to accumulate on this larger loan balance, which increases the total amount you owe.

When Does Interest Capitalization Occur?

For both federal student loans and private student loans, capitalization can happen during several key points in the loan lifecycle:

1. Grace Period

After graduation, leaving school, or dropping below half-time enrollment, you may be given a grace period before your loan payments are due. If your loans are unsubsidized federal loans or private student loans, any interest that accumulates during this time may be capitalized.

2. Deferment or Forbearance

If you qualify for a deferment or forbearance due to financial hardship or other reasons, interest will likely continue to accrue during this period. In most cases, this interest will be capitalized once the deferment or forbearance period ends and you begin repaying the loan again.

3. Repayment Period

In some cases, lenders may capitalize interest at regular intervals during the repayment period—such as every three, six months, or annually. This practice can increase the loan balance gradually over time, leading to more significant costs in the long run.

Why Does Capitalized Interest Matter?

Capitalizing interest can significantly affect the total cost of your loan. Here’s why it matters:

1. Increased Loan Balance

When interest is capitalized, it is added to the principal amount of your loan. This means that the next time your loan accrues interest, it will be calculated on the new, larger balance. This leads to more interest being charged in the future, and over time, the amount you owe can grow significantly, making it harder to pay off your debt.

2. Higher Monthly Payments

As a result of a larger loan balance, your monthly payments will also increase. Even if your interest rate remains the same, capitalizing interest increases the amount you owe, which means you’ll pay more each month once repayment begins again. If you’re in a situation where you were relying on a temporary deferment or forbearance, the amount owed after the interest capitalization may surprise you with higher-than-expected monthly payments.

3. Longer Loan Repayment Period

Because capitalized interest increases the total balance of your loan, it can extend the period of time required to fully repay the loan. This means you may end up paying off the loan over a longer period than initially planned, resulting in paying more in interest over the life of the loan.

Does Interest Capitalization Happen With All Student Loans?

No, interest capitalization doesn’t happen with all types of student loans. Here’s what to know:

1. Federal Subsidized Loans

With federal subsidized loans, the government covers the interest while you’re in school, during your grace period, and while you’re in deferment. Therefore, there is no interest capitalization during these periods. However, interest will still accrue on federal unsubsidized loans and private loans, and those will be capitalized if not paid during deferment or forbearance periods.

2. Private Student Loans

With private student loans, interest typically accrues during deferment and forbearance periods, and it will almost certainly be capitalized once the deferment period ends. Some private lenders will capitalize interest every few months, while others do it annually, so it’s important to know the terms of your loan agreement to understand when capitalization will occur.

How to Minimize Capitalized Interest

While you can’t always avoid capitalized interest entirely, there are steps you can take to minimize its impact:

1. Pay Interest During Deferment or Forbearance

If you’re in a deferment or forbearance period, try to pay at least the interest as it accrues. This can prevent the interest from being added to the principal and capitalizing, which helps keep your loan balance manageable.

2. Avoid Unnecessary Forbearance or Deferment

Only use forbearance or deferment if absolutely necessary. If you can make partial payments or interest-only payments, this can help keep your loan balance from increasing unnecessarily. Deferring or forbearance periods can be helpful in financial hardship, but they can also extend the life of the loan if interest is allowed to accumulate.

3. Refinance Your Loan

Consider refinancing your student loans if you have a good credit score and a stable income. Refinancing can potentially lower your interest rate, and it could reduce the total amount of interest you pay over the life of the loan, as well as help you pay off your debt faster.

Capitalized interest is an important concept to understand when managing your student loans. While it can be a helpful tool for temporarily postponing payments, it can significantly increase the total amount you owe once interest is added to the principal. It’s important to stay aware of your loan terms, check your statements regularly, and take steps to minimize capitalized interest when possible. If you’re unsure how capitalized interest applies to your situation, contact your loan servicer or lender for more information, as the policies can vary.