You’ve been paying on your student loans for years. But you just checked the balance and it hasn’t gone down. Instead, it’s gone up. A lot. Of course, interest is to blame. Your interest rate is likely really high. But another culprit is likely to blame as well: capitalized interest on a student loan.
In this post, we’ll explain what capitalized interest on a student loan is. We’ll also provide a student loan capitalized interest example.
After that, we’ll answer:
- What is student loan capitalized interest?
- When is student loan interest capitalize
- How to avoid capitalized interest on a student loan
- Capitalized student loan interest is tax deductible
With our roadmap set, let’s get to it.
What is student loan interest capitalization and how does it affect a student loan
Let’s start with the basics.
Capitalization occurs when accrued (that is, unpaid) interest is added to your principal balance. Essentially, from that point forward, you’re paying interest on interest. And that’s terrible because after interest capitalizes, the time needed to pay off your federal or private student loans will have increased ---- dramatically.
And that’s the exact opposite outcome you want.
To help us better understand how capitalized interest affects a student loan let’s get an example.
Example of student loan capitalized interest is calculated
Let’s start with a basic formula for finding accrued interest:
Interest accrued = The Daily Interest Rate x The Accrual period x Outstanding principal balance.
The daily interest rate is your annual interest rate divided by 100 and then that resulting number divided by 365.
The accrual period is the number of days over which you’ll calculate interest. Basically, this is how long your deferment, forbearance, or grace period lasts.
And the outstanding principal balance, is well, the principal balance you owe without interest.
With those definitions out the way, let’s use this example:
Taylor owes $10 thousand for an unsubsidized student loan that has a 10% annual interest rate. She placed that loan in a deferment that will last 180 days.
Based on those numbers, she will accrue about $493 in interest during the forbearance.
That means once she leaves the forbearance, that unpaid interest will capitalize. And that would increase her new principal balance to $10,493.
Okay, that’s enough math for me.
Let’s get back to answering questions.
When is student loan unpaid interest capitalized?
The simple answer is that your unpaid interest on your student loans capitalizes anytime you’re not paying on your loans.
With federal student loans, this means student loan unpaid interest capitalizes when:
- After a grace period on an unsubsidized loan;
- After a deferment on an unsubsidized loan;
- After a forbearance on both subsidized and unsubsidized loans; and
- When you consolidate federal student loans.
Capitalization also occurs in these instances with the income driven repayment plans:
- When you leave the Revised Pay As You Earn (REPAYE) plan;
- When you leave the Pay As You Earn (PAYE) plan;
- When you leave the Income Based Repayment (IBR) plan;
- When you fail to timely recertify your income annually with the income driven repayment plans;
- When you no longer qualify for the PAYE or IBR plan; and
- When you’re on the Income Contingent Repayment (ICR) plan your interest capitalizes annually.
For private student loans, interest capitalization typically happens:
- At the end of a grace period;
- After a deferment; and
- After a forbearance.
- Three reasons why the PAYE plan is better than the REPAYE plan
- Private student loan forgiveness exists (but only if you're dead or disabled)
Now that we know when student loan unpaid interest capitalizes, let’s learn…
How to avoid capitalized interest on a student loan
The easiest way to avoid interest capitalization on your student loan is to pay off the interest before it’s added to your balance. This only works if you were in a grace period, deferment for an unsubsidized loan, or a forbearance, or before you consolidate your student loans.
You can pay off the interest either by making monthly payments while you’re in a period of nonpayment or by making a lump sum payment before the period ends.
But what about when you’re in an income driven repayment plan?
In that case, you can avoid having your unpaid interest capitalized by:
- Timely submitting your annual recertification for your income driven repayment plan;
- Pay your loans under the REPAYE, PAYE, or IBR plan rather than the ICR plan;
- Pick one income driven repayment plan and stay in it.
For those of you with Parent Plus loans, you’re screwed. The only income driven repayment plan you qualify is for the ICR plan. And that’s only if you consolidated your Parent Plus loan into a Direct Parent Plus Consolidation Loan.
Is capitalized student loan interest deductible
So let’s say you couldn’t avoid having the interest capitalized on your student loans.
Obviously, that sucks.
But there’s one positive:
The interest capitalization may be tax deductible.
I say may because you can deduct the capitalized interest only if you made payments on your student loan during that year.
Reading this, you might ask:
Can I claim the capitalized interest deduction if I have a $0 payment under my income driven repayment plan?
I would argue you can because the $0 payment is technically a payment. It’s what the Department of Education says all you can afford to pay towards your student loans.
Keep in mind, this is just what I think. You should speak with a qualified tax professional to get their advice.
Here’s what you need to know:
Student loan interest capitalization is bad. It increases your principal balance. And that causes you to take much longer to pay off your student loans.
You can avoid this harmful affect by paying off the unpaid interest before your period of nonpayment ends and by effectively managing your income driven repayment plans.