How Does Capitalized Interest Affect My Student Loans?

Whether your student loans are federal or private, you are being charged interest on the money that you borrowed.

However, you might be wondering when does interest actually start being charged? What happens to that interest if you don’t pay it? How can you prevent capitalized interest from getting out of control and derailing your debt payments?

Let’s dive into the nitty-gritty and find out.

What is capitalized interest?

According to Sallie Mae, the interest on your student loan starts on the first day your lender sends funds from your loan to either you or your school.

Interest on your loan grows daily, and you will continue to pay interest on your loan until it is paid off. Your loan’s interest rate is listed in your Disclosure Documents and billing statement.

“Capitalized” means added to the Current Principal or balance on the loan that you still owe. Your interest is no longer in a separate category as your loan principal.

Since interest has been building since the start of the loan, your billing statement might show a balance that’s larger than the original amount you borrowed.

Once interest is capitalized, your student loan servicer will begin charging you interest on that amount as well. This can significantly increase the amount of your monthly payment and add years to your repayment term.

Paying interest on subsidized loans

When a loan is subsidized, another entity (not you) is paying the interest during certain qualifying periods. Federal direct subsidized loans are the most common ones under this category. With these loans, the federal government pays your interest during the following circumstances:

  • while you’re enrolled in school at least half-time
  • for the first six months after you leave school (this is referred to as a grace period)
  • during a period of deferment (a postponement of loan payments during certain qualifying periods)

These perks, along with others typically available for federal loans like income-driven repayment plans, make federal direct subsidized loans the most desirable if you have to borrow money to fund your education.

However, because these loans are only awarded to undergraduates on the basis of financial need, not everyone qualifies for them.

Even if you have federal direct subsidized loans, keep in mind that interest may build during periods of forbearance when you are not required to make payments. This interest can become capitalized interest and added to your loan balance, which you’ll have to eventually pay.

Paying interest on unsubsidized loans

When a loan is unsubsidized, interest begins accruing as soon as the money is available to you. This means that you are responsible for paying the capitalized interest on your loan regardless of the circumstances.

Federal direct unsubsidized loans are the most common form of these. While unsubsidized loans are not as desirable as subsidized loans, the federal government makes these loans available to graduate students and undergraduate students alike regardless of financial need.

Additionally, federal direct unsubsidized loans are still eligible for income-based repayment, Public Service Loan Forgiveness, other forgiveness programs, as well as deferment and forbearance.

If your unsubsidized loan is federal, you may not be required to make payments while you are in school at least half of the time, or during your grace periods and periods of deferment or forbearance.

However, the “clock” on your interest is always running on federal direct unsubsidized loans, and can become capitalized interest when added to your current principal.

Paying interest on private loans

Private student loans are almost always unsubsidized. As with federal direct unsubsidized loans, interest begins accruing from the time of disbursement. You are responsible for paying interest during all periods.

Like federal direct unsubsidized loans, private student loans are available to all students regardless of financial need. However, private student loans almost always come without the repayment and forgiveness perks that federal loans are eligible for

With private loans, you may or may not have to make payments while in school, there may or may not be a grace period, and deferment or forbearance is typically not an option. But remember, the “clock” is always running on interest for private loans.

How to avoid capitalized interest

Regardless of the type of loan you have, if you have accrued interest by the time that you are required to begin making payments you have three options if you want to avoid capitalized interest.

The first option is to pay the accrued interest in full when you start making payments after the grace period, deferment period, or forbearance period ends for your loan. This can be difficult to achieve depending on your income, the overall loan amount, and the amount of interest you need to pay off.

The second option is to make payments toward your interest as soon as your loans are disbursed. This option can be challenging because it means making payments while you’re still a student. You’ll have to track down your student loan servicer and keep track of how much interest is accruing on your loan.

Depending on your financial circumstances as a student, it may be hard for you to budget student loan payments when you’re living lean and not making much of an income.

However, despite the difficulties associated with making payments while in school, it may be worth the effort because it can prevent your student loan balance from inadvertently ballooning out of control.

Your third option is to optimize your borrowing by maximizing any subsidized loans for which you are eligible before pursuing other options, and borrowing as little as possible in the first place.

Essentially, the more frequently interest is added to the Current Principal, the more interest you will pay. Capitalized interest can become a huge financial burden if left unchecked.

Be sure to have a plan in place for how you want to handle paying the interest on your student loans before your separation period, grace period, forbearance period or deferment period ends.

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