Capitalized Interest: How Does It Work?

The average tuition and fees for full-time undergraduate students at four-year colleges can range from $11,260 for public in-state schools to $41,540 at private colleges, according to College Board. This means that many students will need to take out loans to pay for school. 

When you take out a student loan, you’ll have to pay back the amount you borrow, plus interest. Interest accrues on most types of student loans from the beginning. Sometimes, that interest is added onto your principal loan balance, an event that’s known as interest capitalization. 

Capitalized interest can increase your borrowing costs, since you’ll end up paying back a new, higher loan balance. Here’s a closer look at how capitalized interest works, including ways to prevent interest from capitalizing on your student loan. 

What is capitalized interest on student loans? 

Capitalized interest is interest that’s added onto your principal loan balance. When interest is capitalized, your total loan balance increases. As a result, your monthly payments, daily interest charges, and long-term loan costs go up too. 

Interest only capitalizes in certain circumstances, though. If you can avoid those circumstances — by making interest-only payments during your grace period or another deferment, for example — you can prevent interest from capitalizing and keep your cost of borrowing down. 

You don’t have to worry about making interest-only payments on Direct Subsidized Loans while you’re in school at least half-time, during your grace period, or during another period of deferment, as the government covers interest charges during these times. However, all other student loans, such as federal unsubsidized loans and private student loans, start accruing interest from the date of disbursement. 

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 depending on the type of loan. 

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 will not accrue when your grace period ends, after a forbearance, or after leaving one of the other income-driven repayment plans (PAYE, SAVE, or ICR). 

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 federal unsubsidized or private student loans, consider paying off the interest right away. 
• Make interest-only payments during your grace period: Along similar lines, you could pay off the interest on unsubsidized or private loans during your grace period, which typically lasts for 6 or 9 months after you graduate to give you time to find a job. 
• Chip away at interest during deferment or forbearance: Deferment and forbearance let you postpone payments if you go back to school or run into financial hardship. But interest keeps accruing on most types of loans during these periods, and it may capitalize when they come to an end. If you pay off the interest during this time, there won’t be any accrued interest to add to your principal balance. 
• Choose your repayment plan wisely: Federal loans come with lots of repayment options, but not all of them cover your accrued interest from month to month. If you opt for the 10-year Standard, Extended, or Graduated Repayment Plans, your payments will cover your accrued interest while reducing your principal. The SAVE Plan also has a generous interest subsidy, so you won’t have to worry about interest capitalization. It eliminates any extra interest after you make a full, on-time payment. Compare your options to determine which plan would best fit your budget and help you prevent capitalized interest. 
• 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.