Interest Capitalization Student Loans: How to Avoid It

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Interest capitalization occurs when unpaid interest is added to the principal balance of the loans, thereby increasing your principal loan balance. Interest is then charged on that new loan balance, which increases the overall cost of the loan. Thus, interest capitalization causes you to pay interest on top of interest. Here's what you need to know to stop the balance of your student loan debt from growing due to capitalization.

How does interest accrue on student loans

Whether you have a fixed interest rate or variable interest rate, the interest on your federal and private loans accrues daily. However, you're not being charged compound interest. Instead, you're being charged a daily interest rate.

Your daily interest rate is your annual student loan interest rate divided by the number of days in the year. You calculate the daily interest that accrues on your loan by multiplying your remaining loan balance by your daily interest rate. Here's an example.

Daily Interest Example: You owe $100 thousand a Federal Direct Loan with a 5% interest rate. It's an unsubsidized student loan, so you're responsible for paying all of the interest that accrues. To calculate your daily interest rate, we divide 5% by 365. Your daily interest rate is .00013699. Next, you multiply that rate by the balance of the loan, $100,000, to get the daily interest that's accruing, $13.69.

Under this scenario, your monthly payment would need to be at least $411 ($13.69 x 30) to cover the daily interest accrual. Unfortunately, the required monthly student loan payments for borrowers in IDR Plans typically are not enough to cover the daily accrued interest. As a result, their loan balances will keep growing until they're eligible for IDR loan forgiveness after 20 to 25 years.

Does student loan interest capitalize?

Student loan interest on federal student loan debt capitalizes when a deferment or forbearance period ends or when the borrower defaults on the loan. The Department of Education also capitalizes unpaid interest annually for borrowers in an income-contingent repayment (ICR) plan or an alternative repayment plan. Other income-driven repayment plans like Revised Pay As You Earn (REPAYE) and Income-Based Repayment (IBR) have special rules that limit capitalization on subsidized loans.

For private student loans, the events that cause your interest to capitalize vary from lender to lender. Typically, interest on private student loan debt capitalizes when your grace period ends, at the end of a deferment or forbearance period, or you default.

  • Accrued Interest vs. Capitalized Interest: Interest grows on student loans from the day you borrowed the loans until you pay the balances in full. The interest that grows no your loans is referred to as accrued interest. Capitalized interest, or more specifically, interest capitalization, happens when the accrued interest is added to your loan balance.
  • What is unpaid interest on student loans: Unpaid interest on student loans is the amount of daily accrued interest you failed to pay during a period.
  • Student loan capitalized interest forgiveness: Ordinarily, capitalized interest on student loans can't be forgiven. However, if you default on your loans and negotiate a student loan settlement, the Department of Education and private lenders will typically waive some of the interest that has accrued on your loan balance.
  • Tax deduction for student loan interest capitalization: You can deduct capitalized interest on a student loan if you made a payment during the tax year. Check IRS Form 970 for more details.

What causes interest to capitalize on student loans?

There are several situations in which interest capitalizes.

For federal student loans, capitalization of unpaid interest occurs:

  • Grace period - when a grace period ends
  • Forbearance - when a forbearance ends
  • Deferment - at the end of the deferment period for unsubsidized loans
  • Exit IDR Plan - when you leave the REPAYE, PAYE, or IBR Plan
  • Fail to rectify - failing to timely submit annual recertification for the REPAYE, PAYE, and IBR Plan
  • No partial financial hardship - if you no longer have a partial financial hardship and are no longer eligible for the PAYE or IBR Plan
  • Consolidation - when you consolidate federal loans
  • Default - when you go 270 days without making a required student loan payment

Unpaid interest also capitalizes each year (up to 10% of the loan balance) under the Income-Contingent Repayment Plan. Thankfully, most federal student loan borrowers do not choose to repay their loans under the ICR Plan. However, Parent Plus Loan borrowers who want a payment based on their income don't have a choice. The ICR Plan is the only income-based repayment option that Parent Plus Loan borrowers are eligible for.

For private student loans, interest capitalization typically happens:

  • at the end of the grace period
  • after a period of deferment
  • after a period of forbearance

COVID-19 Forbearance: Non-Capitalizing

The administrative forbearance that's been in place since the coronavirus pandemic started is a non-capitalizing forbearance. However, when the forbearance ends, any accrued interest on your loans before March 13, 2020, may capitalize if:

  • before the suspension of payments began, you were in a deferment or forbearance
  • you were in your grace period before the suspension of payments began

How to avoid interest capitalization

Unless you're making payments under the Standard 10-Year Repayment and rejecting all deferments and forbearances, it's near impossible to avoid capitalized interest on student loans. However, there are steps you can take to reduce the number of times it occurs. Here are 5 steps you can take to lower the amount you pay in student loan interest overall.

  1. Pay interest while you're in school: interest will accrue on your federal and private student loans while you're in school. Covering the daily interest won't affect the principal balance, but it will keep your balance manageable.
  2. Make interest-only payments during deferment/forbearance: if you can afford to pay the daily interest on your loans while in school, you won't have to deal with as much interest when your grace period ends.
  3. Ask for an interest-rate reduction: some private lenders offer interest rate reduction programs. Contact your lender and see if they have a program that gives you a lower interest rate.
  4. Recertify IDR on time: federal student loan borrowers have to complete their annual recertification to remain in an IDR Plan. Be sure to submit your paperwork around month 10 or 11 of your current repayment term.
  5. Choose the Standard 10-Year Repayment Term: your monthly payment under the Standard Plan is sufficient to cover the daily interest plus pay towards your principal balance.

Refinancing is also an option. However, refinancing federal student loans with a private lender causes you to lose certain benefits like loan forgiveness, income-based repayment options, etc.

Want help exploring your repayment options? Let's talk

Finding ways to avoid interest capitalization while repaying your student loan debt can be challenging. Over the years, I've helped many borrowers put together a strategy that limits the amount of interest they'll pay over the life of their student loans.

Let's talk if you'd like me to help you do the same. Schedule a free 10-minute call with me today.

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