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Capitalized Interest: What It Is and How It Works

Capitalized interest means interest is added onto your principal balance. This happens with federal and private student loans and can make repayment costlier.

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By Christy Bieber

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Christy Bieber

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Christy Bieber has been working full-time as a freelance writer since 2008. She has written blogs, news articles, textbooks, and online courses on the topics of law, finance, and history. She lives with her husband, two children, and beagle.

Edited by Renee Fleck

Written by

Renee Fleck

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Renee Fleck is a student loans editor with over five years of experience in digital content editing. Her work has been featured in Fast Company, Morning Brew, and Sidebar.io, among other online publications. She is fluent in Spanish and French and enjoys traveling to new places.

Updated January 29, 2024

Editorial disclosure: Our goal is to give you the tools and confidence you need to improve your finances.

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Capitalized interest occurs when your monthly loan payments are not enough to cover your interest costs. This unpaid interest is eventually added to your principal loan balance in a process called capitalization. When this happens, the total amount you owe on your student loan increases. 

This guide will explain how interest capitalization works and how it affects your ability to pay back your student loans. 

What is capitalized interest? 

Capitalized interest on student loans is any unpaid interest that gets added onto your principal loan balance. When interest capitalizes, your total student loan balance and the amount you have to repay increases. 

Interest capitalization usually happens after your loans come out of deferment or while they’re in forbearance, when you haven’t been making any payments. It can also happen if you're on a payment plan that results in a monthly payment that doesn't cover interest. 

What happens when interest capitalizes?

When interest capitalizes, it increases the total amount you owe. This is because you end up paying interest on a higher balance, which is essentially like paying interest on interest. Paying more over time and each month can be a serious financial burden, especially if you have a large student loan balance already. 

Check Out: What Increases Your Total Loan Balance?

Example of capitalization 

Let’s say you’re in a period of deferment for one year, with a student loan balance of $10,000 at a 5.50% interest rate. Since you’re not making any payments on the balance, you’ll be charged interest that will pile up. Over the course of 12 months, you would incur $550 in interest costs.

When that interest capitalizes after your deferment period ends, your student loan balance would increase from $10,000 to $10,550. Since you now have a $10,550 balance, your monthly payment would increase to $114 and you would pay $3,189 in total interest over the life of the loan. 

If capitalization had not occurred and your loan balance remained at $10,000, your monthly payments would have been $109 and your total interest costs would have been $3,023. 

Accrued vs. capitalized interest

With most federal and private student loans, interest starts accruing as soon as your loans are disbursed. But during periods of deferment or forbearance, this interest isn’t added onto your loan balance right away. It's simply growing. The unpaid interest is called accrued interest.

  • Accrued interest: Interest that accumulates on your loan over time
  • Capitalized interest: When any accrued interest is added to your principal loan balance

If you decide to make interest-only payments while you’re in school or in deferment, you can pay off the accrued interest, which means your loan balance would neither get bigger nor smaller. The principal balance would remain the same, and the money you send to the lender each month or in a lump sum would simply wipe away the accrued interest. 

If you don’t make any payments or don't pay enough to cover the entire interest accrued to date, then the unpaid interest keeps piling up. When a triggering event happens, such as your grace period ending, then all the accrued interest that went unpaid would be added onto your loan balance in a process called capitalization. 

When does interest capitalize?

Here’s when interest capitalizes for different kinds of loans:

Federal student loans

If you have federal student loans, the rules for interest capitalization differ depending on the type of loan you have. If you have Direct Subsidized Loans, you won’t be charged interest when you are in school or in an eligible grace period. If you have other types of federal loans, including Direct Unsubsidized Loans or PLUS loans (which are not subsidized), you are always charged interest. 

For both subsidized and unsubsidized loans, interest capitalization occurs in the following circumstances:

  • When a period of forbearance ends
  • When you change from an Income-Based Repayment plan either because you no longer qualify or because you choose not to use that plan any longer

For all loans that are not unsubsidized, interest capitalization occurs in the above situations and also:

  • At the end of your grace period after graduation
  • At the end of deferment 

Private student loans

For private student loans, capitalization typically happens when you come out of a period of deferment or forbearance, or come out of your grace period. However, you’ll need to check with your particular lender about the rules of capitalization, as the process can vary from one private lender to another. 

How to avoid interest capitalization 

Since interest capitalization makes student loan repayment more expensive, it makes sense to avoid it when possible. You can avoid capitalized interest by taking the following steps:

  • Pay interest charges during deferment: Try to pay enough to cover interest costs each month, even when you’re in school or in a period of deferment or forbearance. You can find out how much interest is accruing by reviewing your loan statements or checking with your loan servicer. 
  • Make a lump-sum interest payment: This could help cover any accrued interest before an event that would trigger it to capitalize. For example, paying off your entire outstanding interest balance before your grace period or deferment ends would prevent the interest from capitalizing. 
  • Avoid deferment and forbearance: If you can avoid pausing your loan payments, you’ll be less likely to accumulate interest that could be capitalized.

It can be a challenge to come up with money while in school or during other periods of economic hardship when your loans might be in deferment. But paying off accrued interest to prevent it from capitalizing can make a big difference in your total borrowing costs. Every little bit can help.

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Meet the expert:
Christy Bieber

Christy Bieber has been working full-time as a freelance writer since 2008. She has written blogs, news articles, textbooks, and online courses on the topics of law, finance, and history. She lives with her husband, two children, and beagle.