Hidden Costs of Federal Direct Unsubsidized Student Loans

Student borrowers who earn a four-year degree from a public school carry an average student loan debt balance of $27,420 by the time they walk the stage at graduation, according to data compiled by the College Board. 

For some, this balance includes Direct Unsubsidized Loans, which have been accruing interest since the day the student received the funds. Unfortunately, this unpaid interest is a hidden cost of federal Direct Unsubsidized Loans that many borrowers aren't aware of. 

This guide explores how federal unsubsidized loan interest works and how capitalized interest on these loans can cost you. 

Current private student loan rates

What is a Federal Direct Unsubsidized Loan?

Federal Direct Unsubsidized Loans are available from the Department of Education to help eligible students pay for school.

Unsubsidized loans are one of two types of federal student loans offered to undergraduate and graduate students. Direct Subsidized Loans are the other.  

In contrast to Direct Subsidized Loans, which don’t accumulate interest during school, unsubsidized loans begin to accrue interest from the moment the funds are disbursed. 

Interest accrues on unsubsidized student loans while you’re in school

You aren't required to make monthly payments on subsidized or unsubsidized loans while you're in school, or during a six-month grace period after leaving school. 

However, since Direct Unsubsidized Loans begin accruing interest immediately, interest charges accumulate during this time. Student loan interest also accumulates during any deferment or forbearance periods. This interest may eventually be added to the amount you owe.

“The balance can grow with continued interest over the years if it isn’t paid, and that’s a big surprise for many borrowers after graduation,” explains Mario Serralta, CPA and founding lawyer of Mario Serralta & Associates. 

Because subsidized loans don't charge interest while you are in school or during periods of deferment, Direct Unsubsidized Loans are generally more expensive than this federal loan alternative.

Interest capitalization increases your unsubsidized student loan balance

Interest capitalization adds to the costs of your unsubsidized loan. Capitalization occurs when unpaid interest is added to the principal balance, causing the loan balance to increase and resulting in interest being charged on interest. 

While interest accumulates on unsubsidized loans from day one, unpaid interest charges are capitalized, or added to your loan balance, when certain triggering events happen, including the following.

• The end of your post-graduation grace period
• Leaving a period of deferment
• Leaving a period of forbearance
• If you lose eligibility for your income-based repayment (IBR) plan

Capitalized interest causes you to pay a bigger balance and higher total interest costs over time.

Unsubsidized loan origination fees reduce the amount you receive

Accumulating interest isn't the only hidden cost of Direct Unsubsidized Loans. Borrowers must also pay an origination fee, which totals 1.057% for loans first disbursed on or after Oct. 1, 2020. 

The Department of Education deducts the origination fee before disbursing loan funds. For many borrowers, this fee explains why they received a smaller deposit than they expected. 

Long-term cost of minimum payments on unsubsidized loans

Borrowers may also increase the cost of unsubsidized loans when they choose an income-driven repayment plan or extend their loan repayment timeline by choosing a longer repayment term. 

While these payment options offer lower monthly payments and give borrowers some breathing room in their budgets, paying interest for longer adds to total loan expenses.

Say you earn $40,000 annually, expect your income to grow by 3% annually, and have $20,000 in Direct Unsubsidized Loans with a 6.39% interest rate. 

• If you opt for the 10-year Standard Repayment Plan, you’ll have a $226 monthly payment for the full 10 years and will pay a total of $27,117. 
• If you choose the Income-Based Repayment (IBR) Plan, you’ll start with a $138 monthly payment, which will eventually rise to $226. But you’ll pay a total of $32,368 to pay down the debt. 

While the lower payments that come with a longer loan term are nice, the extra interest you pay is a big downside. 

Unsubsidized federal student loans vs. other options

Direct Unsubsidized Loans aren’t your only borrowing option. It’s helpful to explore all of your loan choices before you commit to them. 

Other student loans you may want to consider include:

• Direct Subsidized Loans: These loans are available to undergraduates with demonstrated financial need. If you qualify, prioritize these loans first because interest won’t accumulate while you're in school. 
• PLUS loans: Parents of dependent undergraduates and graduate students may be eligible for PLUS loans. However, these have higher interest rates and origination fees than subsidized or unsubsidized loans and also begin accruing interest as soon as funds are disbursed. 
• Private student loans: Like Direct Unsubsidized Loans, most private loans start to accrue interest immediately after disbursement. And, while some lenders don't charge an origination fee, private lenders often charge higher interest rates and offer fewer borrower protections than federal student loans. 

How to reduce the cost of unsubsidized student loans

Making payments while you're in school is the best way to reduce the total costs of an unsubsidized loan. 

“Paying interest as you go will help shoulder the burden of the growing balance and can make a big difference,” says Leslie Tayne, founding attorney at Tayne Law Group. 

Tanye continues, “Another tip is to pay towards the principal balance whenever possible.”

Beyond chipping away at the loan balance while in school or at least keeping up with the interest charges, make it a priority to only borrow what you need. If possible, consider working a part-time job to help you lower the amount you’ll need to borrow for school. 

After graduation, consider picking a shorter repayment term to keep total borrowing costs as low as possible. Refinancing could also be an option to make the payoff easier if you qualify for a lower rate, but giving up federal student loan benefits is a major downside, so carefully consider the protections you'd be giving up before refinancing.