Capitalized Interest: What It Is, How It Works, and Examples

Interest starts accruing on most student loans as soon as the loan is disbursed. In some cases, unpaid interest is later added to your principal balance in a process known as capitalization.

When that happens, you begin paying interest on a larger balance, which can increase the total cost of your student loan. Here’s how capitalized interest works, when it happens, and how you may be able to prevent it. 

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What is capitalized interest on student loans? 

Capitalized interest is unpaid interest that gets added to your student loan’s principal balance. Once that happens, you begin paying interest on a larger balance, which can increase your monthly payment and the total amount you repay over time.

Interest only capitalizes in certain circumstances. For most federal student loans, one of the most common triggers is the end of a deferment. Private lenders set their own rules for when interest capitalizes.

Example of capitalized interest 

Consider the following example of capitalized interest. Let’s say you borrowed $29,400 in Direct Unsubsidized Loans at a 6.53% interest rate. On a 10-year repayment plan, $5.26 in interest would accrue on your loan balance each day. 

Now, let’s say that you put your loans into deferment for 12 months. Over the year, a total of about $1,920 ($5.26 x 365) would accrue on your loans. Once you leave deferment, that $1,920 would be added to your principal balance. 

Your new principal balance would be $31,320, which would cause your monthly payments and interest charges to increase along with it. In total, you’d end up paying $2,620 more on this new, higher balance due to capitalized interest. 

When does interest capitalize?

Interest capitalizes on student loans in a few specific circumstances, which vary by loan type. 

On federal student loans

If you hold Direct Loans or Federal Family Education Loans (FFEL) that are managed by the Department of Education (ED), interest will capitalize: 

• After a period of deferment ends on an unsubsidized loan 
• After you leave the Income-Based Repayment (IBR) Plan voluntarily or because you no longer qualify for it 

Interest that accrues during your grace period does not capitalize on most federal student loans. Except for Direct Subsidized Loans, interest generally continues to build during the grace period and remains part of the total amount you owe. Even though it isn’t added to your principal, that unpaid interest can still increase your monthly payment on a fixed repayment plan or lengthen your repayment timeline on an income-driven repayment (IDR) plan. 

On FFEL loans not managed by ED 

The FFEL program stopped lending in 2010, but you may owe on FFEL loans if you borrowed prior to that time. If you owe on any FFEL loans that are not managed by the ED, interest can be capitalized on them: 

• After a deferment or grace period on an unsubsidized loan 
• After a forbearance on any type of FFEL loan 
• After leaving the IBR Plan or no longer qualifying for it

On private student loans 

For private student loans, the rules around interest capitalization can vary from one lender to another. However, interest may capitalize after your grace period ends and you enter repayment. It could also capitalize after a period of deferment or forbearance. 

How to prevent interest from capitalizing 

Capitalized interest can make your student loans even more expensive, since you essentially end up paying interest on top of interest. Here are some ways you can prevent interest from capitalizing, or at least reduce its costly impact: 

• Pay off interest charges while you’re in school: You’re generally not required to pay anything on your student loans while you’re studying for your degree, but paying off the interest as it accrues could keep your balance from ballooning. If you borrowed private student loans, consider paying off the interest right away.  
• Chip away at interest during deferment: Deferment lets you postpone payments if you go back to school or run into financial hardship. But interest keeps accruing on most types of loans during this period, and it may capitalize when repayment begins. If you pay the interest during this time, there won’t be any accrued interest to add to your principal balance. 
• Consider RAP if you’re eligible: The Repayment Assistance Plan (RAP) can prevent unpaid interest from increasing your loan balance. If your monthly RAP payment doesn’t cover all the interest that accrues that month, the remaining interest is waived after you make your payment. 
• If on IBR, recertify your plan every year: If you’re on the Income-Based Repayment Plan, make sure to recertify your income annually so you don’t get kicked off the plan, which can cause interest to capitalize on your student loans.