Understanding Capitalized Interest on Student Loans

August 11, 2021 · 7 minute read

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Understanding Capitalized Interest on Student Loans

Most everyone who takes out a student loan understands this, but it’s still worth repeating: Students usually pay back more than the amount they borrowed to pay for school.

That’s because borrowing money to pay for school comes at a cost—in the form of interest. Interest is generally charged as a percentage of the principal (or initial) amount borrowed.

In certain situations, interest that has accrued, or been earned over time, may be capitalized on the loan. This means that the accrued interest is added to the principal value of the loan. This new value is then used to calculate the amount of interest owed each day (depending on the type of debt interest may accrue on a different schedule but federal student loans accrue interest on a daily basis). So if you’ve ever heard someone say capitalized interest is when interest is charged on interest, that’s why.

On federal student loans interest starts accruing as soon as they are disbursed. Students who have subsidized student loans don’t have to worry about interest accruing while they are in school or during their grace period. For other types of federal student loans, including unsubsidized loans and PLUS loans, borrowers are responsible for paying the accrued interest. Unpaid interest is capitalized on the loan. This can happen, for example, after periods of deferment or after the grace period on an unsubsidized loan.

Capitalized interest can dramatically increase how much a borrower owes over time. Some people continue repaying student loans even as they near retirement and they may have had the interest on their student loans capitalized at some point. Read on for a more in-depth discussion on capitalized interest and student loans. 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.

Generally, federal loans have fixed interest rates, while private loans may 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%. When you factor in compound interest, 7% can amount to a lot. 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, take a look at SoFi’s student loan payoff calculator.)

When Does Interest Accrue?

Interest on federal student loans begins to accrue the day that the loans are disbursed, which means the day the loan is paid out by the lender it starts accruing interest. As mentioned earlier, federal student loans accrue interest daily throughout the lifespan of the loan. This is likely the case for many private student loans, but be sure to confirm the terms with the lender before borrowing. Regardless of whether the student loan is federal or private, the promissory note generally includes all pertinent information on the loan.

Depending on the type of loan(s) a borrower has—subsidized or unsubsidized—they may or may not be responsible for paying for the interest charges accrued while they are enrolled in school and during periods of deferment or forbearance.

As stated earlier, 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).

Understanding Interest During Deferment or Forbearance

For a variety of reasons, such as economic hardship or job loss, students may be able to temporarily 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.

Recommended: Examining How Student Loan Deferment Works

It’s important to understand whether or not the interest will be capitalized on the loan before filing for deferment or forbearance. This can help borrowers prepare for what lies ahead.

What Is Capitalized Interest On A Student Loan?

When accrued interest is unpaid, it is added to the principal value of the loan. This new loan principal becomes the value that is used to calculate the interest. Because the borrower is now paying interest on top of this new, higher loan balance, future payments will also be higher.

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.

Borrowers making use of income-driven repayment plans may want to pay attention to capitalized interest as well. In these situations, unpaid interest may be capitalized on the loan:

•  If an individual voluntarily leaves the Revised Pay as You Earn, Pay as You Earn, or Income-Based Repayment plans.

•  For some income-driven repayment plans, if the borrower does not update their income each year.

•  If a borrower is repaying their loan using the PAYE or IBR income-driven plan and they no longer qualify to make payments based on their income.

In general, unpaid interest is added to the principal of a loan during any major change to the status of the student loan.

Ways to Minimize Capitalized Interest

There are a few ways that borrowers can try to minimize capitalized interest. 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.

Making Interest-Only Payments

One way is to make interest-only payments while in-school, during the loan’s grace period, or during periods of deferment or forbearance. If that isn’t in the cards, consider minimizing the amount borrowed.

Applying for Scholarships and Grants

Even if those who are already enrolled in school and have already received their financial aid award can continue looking for scholarships or grant money. While loans charge interest for the cost of borrowing the money, scholarships and grants are free in the sense that they are not required to be repaid. However, it is likely that getting a scholarship requires students to work hard and maintain their grades in college.

Think Carefully Before Taking a Deferment or Forbearance

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 minimize the amount of interest that may ultimately be capitalized on the loan.

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The Takeaway

When the accrued interest on federal student loans is unpaid, it may be added to the principal value of the loan under certain circumstances. This becomes the new principal value of the loan and is used to calculate the interest as it accrues moving forward. This is capitalized interest. In the long term, capitalized interest can make the cost of borrowing more expensive.

One option that may help some borrower reduce the interest they pay over the life of the loan is student loan refinancing. Qualifying borrowers may be able to secure a lower interest rate. Refinancing student loans may be an option, however, the borrower will forfeit access to federal repayment programs such as income-driven repayment plans.

Find out what student loan refinancing with SoFi could look like for your loans. Get a quote to see if you pre-qualify and at what rate, in just a few minutes.

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SoFi Student Loan Refinance
If you are looking to refinance federal student loans, please be aware that the White House has announced up to $20,000 of student loan forgiveness for Pell Grant recipients and $10,000 for qualifying borrowers whose student loans are federally held. Additionally, the federal student loan payment pause and interest holiday has been extended beyond December 31, 2022. Please carefully consider these changes before refinancing federally held loans with SoFi, since the amount or portion of your federal student debt that you refinance will no longer qualify for the federal loan payment suspension, interest waiver, or any other current or future benefits applicable to federal loans. If you qualify for federal student loan forgiveness and still wish to refinance, leave unrefinanced the amount you expect to be forgiven to receive your federal benefit.

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Notice: SoFi refinance loans are private loans and do not have the same repayment options that the federal loan program offers such as Income-Driven Repayment plans, including Income-Contingent Repayment or PAYE. SoFi always recommends that you consult a qualified financial advisor to discuss what is best for your unique situation.

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