Capitalized interest is unpaid interest that’s added to your student loan balance after you leave school, change repayment plans, or are granted relief from your payments.
Once your unpaid interest is capitalized (added to your loan principal), your monthly payment and interest charges may go up, increasing your total repayment costs. So it’s best to avoid interest capitalization if you can.
Here’s how unpaid interest may capitalize:
- When you leave school
- When you’re granted payment relief
- When you leave income-driven repayment
- When you consolidate your loans
How interest capitalizes when you leave school
With federal student loans and most private student loans, you can choose to make partial payments while attending school or put off repaying your loans altogether until six months after leaving school.
Let’s say each year you’re in college, you borrow up to the maximum limit for federal direct unsubsidized student loans for undergraduates. If you graduate in four years, you’ll take out a total of $27,000 in loans. But when your $3,511 in unpaid interest is capitalized six months after graduation, your loan balance will grow to $30,511.
| Year in school | Amount borrowed | Interest rate | Capitalized interest | |
|---|---|---|---|---|
| Freshman | $5,500 | 4.53% | $1,121 | |
| Sophomore | $6,500 | 4.53% | $1,031 | |
| Junior | $7,500 | 4.53% | $849 | |
| Senior | $7,500 | 4.53% | $510 | |
| Total | $27,000 | $3,511 |
How much does capitalized interest increase your monthly payment and total repayment?
- If your loan balance had stayed at $27,000: Your monthly payments on the standard 10-year repayment plan would have been about $280 a month, totalling $33,626.
- After interest capitalization: The monthly payments on your $30,511 loan balance would be $317 a month for 10 years, a total of $37,998.
That’s a difference of $4,372. This is a good example of why need-based federal subsidized student loans are such a good deal — you’re not charged interest while you’re in school, during your 6-month grace period, or if you’re granted deferment.
Student Loan Interest Rates: Federal, Private, and Refinancing
How interest capitalizes when you’re granted payment relief
Unpaid interest may accrue when you’ve been granted temporary forbearance or deferment of your loan payments. You may be granted forbearance or deferment if you lose your job or go back to school after you graduate.
Let’s say that after your grace period, you decide to go to graduate school instead of getting a job. You defer payments on your $30,511 in undergraduate loans for three years while you’re in law school, plus an additional six months while you take the bar exam and land a job.
Cost to defer $30,511 in undergraduate loans at 4.53% interest:
| Months in deferment | Unpaid interest | New loan balance (if capitalized) |
|---|---|---|
| 6 | $691 | $31,202 |
| 12 | $1,382 | $31,893 |
| 24 | $2,764 | $33,275 |
| 36 | $4,146 | $34,657 |
| 42 | $4,838 | $35,349 |
If you defer payments for 42 months on $30,511 in loans that you’re paying 4.53% interest on, you’ll rack up another $4,838 in unpaid interest charges. When that interest is capitalized, your outstanding loan balance will grow to $35,349.
This means the outstanding balance on the original $27,000 you borrowed to earn your bachelor’s degree has now ballooned by $8,349, as unpaid interest was capitalized after you earned each of your degrees.
Student Loan Deferment and Forbearance: Everything Borrowers Need to Know
How interest capitalizes when you leave income-driven repayment
Unpaid interest can also pile up when you’re enrolled in an income-driven repayment plan. This happens if your monthly payments aren’t big enough to cover the interest you owe.
Unpaid interest that accrues in an IDR plan may be capitalized if you:
- Voluntarily leave the Pay as You Earn (PAYE), Revised Pay as You Earn (REPAYE), or Income-Based Repayment (IBR) plans
- Fail to recertify your income each year you’re enrolled
- No longer qualify for the PAYE or IBR plans based on your income
When unpaid interest is capitalized in an IDR plan
The unpaid interest that you rack up while you’re enrolled in most IDR plans is not capitalized — added to your principal — until you leave the plan or qualify for loan forgiveness. In an IDR plan, you may not be paying down the principal, but it can’t get any bigger while you remain in the plan. The only exception is ICR, where unpaid interest is capitalized annually.
Thanks to the unpaid interest benefit, interest capitalization may be of little or no concern if you leave an IDR plan after only being enrolled for three years or less. Also, if your monthly payments were big enough to cover the interest owed, you wouldn’t have any unpaid interest added to your loan balance no matter how long you were in an IDR plan.
But interest capitalization can be an issue for borrowers who have been enrolled in an IDR for an extended period of time — particularly if they have been paying back student loan debt that exceeds their annual income.
Unpaid interest benefit: PAYE and IBR
Most IDR plans have several features that limit the impacts of unpaid interest. For the first three years you’re enrolled in PAYE and IBR, you’re off the hook for unpaid interest on need-based federal direct subsidized loans.
Whatever interest your monthly payment doesn’t cover is waived. But keep in mind that for PAYE and IBR, the unpaid interest benefit only applies to need-based subsidized loans.
Unpaid interest benefit: REPAYE
The REPAYE plan has a more generous unpaid interest benefit that also applies to unsubsidized loans. Half of unpaid interest on unsubsidized loans is waived for as long as you are in the program. All unpaid interest on subsidized loans is waived for the first three years; after that the government picks up half the tab.
No unpaid interest benefit: ICR
The least generous (and least used) IDR plan, ICR, provides no interest benefit. If your monthly payment doesn’t cover all the interest on your loans, you’re still on the hook.
How interest capitalizes when you consolidate your loans
If you decide to combine several federal loans into a federal Direct Consolidation Loan, any outstanding interest on the loans that you consolidate becomes part of the original principal balance on your consolidation loan.
This is something to keep in mind if you’ve been racking up unpaid interest during your grace period, in an IDR plan, or in deferment or forbearance. If federal loan consolidation triggers capitalization of unpaid interest, you may pay interest charges on a higher principal balance than might have been the case if you hadn’t consolidated.
The same can happen if you refinance federal student loans with a private lender. If you’re enrolled in an IDR plan, and unpaid interest has been racking up because your monthly payments didn’t cover the interest you owed, refinancing can trigger capitalization.
Learn More: Student Loan Consolidation vs. Student Loan Refinancing
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How to avoid capitalized interest
While it would be nice if you could avoid capitalized interest altogether, in many cases it’s not possible.
You’re given the option of not making loan payments while you’re in school because most of your time will be devoted to your studies. After you’ve graduated, if you need a break in your payments, it’s usually because you’ve run into unexpected financial difficulties.
But if your finances allow, here are three strategies for avoiding capitalization of unpaid interest:
- Make partial payments while in school: If you can pay just the interest you owe, or some portion of it, that will reduce the amount of unpaid interest that’s capitalized after you leave school.
- Avoid deferment or forbearance: If you have federal loans and qualify for income-driven repayment, an IDR plan can make your monthly payments more manageable, and you may rack up less unpaid interest
- Take care of unpaid interest before it’s capitalized: If you’re planning to leave an income-driven repayment plan, or are facing another event that can trigger capitalization, paying off any unpaid interest will prevent it from being added to your loan balance.
See: 11 Strategies for Paying Off Your Student Loans Faster
