Most everyone who takes out a student loan understands this, but it’s still worth saying again and again: Students usually pay back more than the amount they borrowed to pay for school.
Sometimes, the amount paid back is significantly more than what was borrowed. That’s because of interest , which is a percentage of the loan paid to the lender for the privilege of borrowing money. (No such things as free money, even if you’re planning to pay it back, unfortunately.)
The way interest works can already feel sneaky and is not always well understood. And then, there’s interest that gets charged on top of interest, a phenomenon that’s known by another name: capitalized interest.
In an ideal world, every student who was ever issued a student loan got a thorough education on how interest works, including an emphasis on the effects of capitalized interest on student loans. But as we know, this doesn’t usually happen.
So, what is capitalized interest? Who does it affect? Below is a discussion of capitalized interest on student loans and how it affects what a borrower owes over time. Additionally, we’ll cover some ways to help you reduce the impact of capitalized interest so that you’re not paying any more in interest than is absolutely necessary.
How Student Loans Work
An undergraduate or graduate student (or their parents) can take out a loan for school from the government, which is called a federal loan, or from a private bank or lender, which is known as a private loan. Federal loans typically offer more flexibility in their repayment plans, and private loans will vary from lender to lender.
Most all federal loans have fixed interest rates, while private loans often offer fixed or variable rates. A fixed rate will stay the same throughout the duration of the loan, while a variable rate is pegged to market rates and could fluctuate.
Interest is typically quoted as a percentage, such as 7%. It may seem small—can you imagine a 7% sale at the local Best Buy or Banana Republic? It’s nothing. But 7% interest compounded on a loan can amount to a big number over time.
For example, assuming there were no extra fees, 7% interest charged on a $30,000 loan would generate around $11,799 in interest charges over a 10-year repayment term. That’s more than a third of the value of the original loan. (To estimate what you could owe in interest on your student loans, you can use an online student loan calculator .)
When Does Interest Accrue?
Unbeknownst to many borrowers, interest on student loans begins to accrue the day that the loans are disbursed and continues to accrue daily throughout the lifespan of the loan. This is the case for all federal loans and is likely the case for many private student loans. No matter which type of loan you have, understand your student loan promissory note or other disclosure notice which includes all pertinent information on your loan.
Depending on the type of loan or loans a borrower has—subsidized or unsubsidized —some may not be responsible for paying for the interest charges accrued while they are enrolled in school and during periods of deferment or forbearance (more on that in a moment).
The government pays the interest charges on subsidized loans while students are enrolled at least half-time. Borrowers pay for the interest accrued on unsubsidized loans and for most private loans immediately once they’re disbursed.
Immediately after graduation, most federal loans offer a six-month grace period where borrowers aren’t required to make loan payments. The grace period exists for recent graduates to have time to find work. Not all loans have grace periods and even if they do, interest may still accrue during the grace period (although a borrower may not be responsible for paying it during this time).
For a variety of reasons, such as economic hardship or job loss, students may be able to halt their student loan payments with programs such as deferment or forbearance . As with a grace period, interest may accrue during these periods.
Borrowers with subsidized loans won’t have to pay interest accrued during periods of deferment, because the government covers those interest charges. However, the government pays no interest charges on unsubsidized loans during deferment and does not make interest payments on any loan types during periods of forbearance.
All borrowers should understand whether they are responsible for paying back the interest accrued before taking any sort of break from paying loans, because it could be a really rude awakening to come back to a freshly capitalized loan.
What is Capitalized Interest?
Capitalized interest is interest that accrues on a loan, and if it isn’t paid, it’s then tacked on top of the principal balance of the loan. Any interest payments thereafter will be calculated on top of this new balance.
Because the borrower is now paying interest on top of this new, higher loan balance, all future payments will also be higher. Another term for capitalized interest is compound interest, the phenomenon of paying (or earning) interest on top of interest. It’s a great thing when it’s earned, not so much when it’s owed.
Capitalized Interest Student Loans
Capitalized interest can happen on student loans in several scenarios. First, it may happen after a borrower graduates from school (or after a grace period), and unpaid interest is added to the balance of the loan. Second, it could happen after periods of student loan forbearance or deferment.
Even though payments are not due during these exceptional periods, interest is often calculated to be added to the balance of the loan once that period is over—this is the process of capitalization and will increase the student loan balance.
Interest can also capitalize on student loans when the loan enters default, or when their six-month grace period ends. The lesson here? Unpaid interest is generally added to the principal of a loan during any major change to the status of the student loan.
Ways to Minimize Capitalized Interest
If at all possible, borrowers can try making interest-only payments while in school. If that isn’t in the cards, just stay informed about how much loaned money being used and try to minimize the amount spent. Try not to use loaned money for things like spring break trips to Cabo or major apartment upgrades—it’s so tempting at the time, but you may regret it in the long run.
Even if you’re already enrolled in school and your school has already determined your benefits package, consider looking for additional scholarships or grant money. You can apply for free money every year.
Graduates should be judicious about taking a deferment or forbearance period, whether this period is immediately following school or arises after a borrower loses their job. While a borrower shouldn’t feel bad about utilizing these programs when needed—that’s why they exist—it’s smart to do so only if totally necessary.
And if a borrower puts their loans in deferment or forbearance, they can try making interest-only payments. Even if they’re not able to tackle the principal at this time, making interest payments makes it possible to avoid interest capitalization.
Once interest is capitalized, there is little a borrower can do about it—the trick is to avoid scenarios where interest is capitalized in the first place. There are other actions a borrower can take to help reduce what they owe, though. One such action is to refinance their student loans.
Refinancing Your Student Loans
Student loan refinancing is the process of paying off your existing loans with a new loan that has entirely new terms. This is generally done with a private lender such as SoFi.
Ideally, this new loan will have a lower interest rate, which could save the borrower money on interest payments over time. It may also be possible to choose between fixed and variable rates, or to shorten (or lengthen) your repayment term.
Refinancing can be a great option for those who will not use federal repayment programs such as income-driven repayment and check your rates with SoFi, a company dedicated to making the student loan refinancing process as seamless as possible.
Whether you are looking to borrow for school or refinance your student loans, SoFi can help. See your interest rates in just a few minutes, with no pressure to sign up.
The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Notice: SoFi refinance loans are private loans and do not have the same repayment options that the federal loan program offers such as Income Based Repayment or Income Contingent Repayment or PAYE. SoFi always recommends that you consult a qualified financial advisor to discuss what is best for your unique situation.