What is Capitalized Interest on a Student Loan?

Capitalized interest is unpaid interest that is added on to your principal — the amount you actually borrowed — so you end up paying interest on top of interest. Unless you have a subsidized loan, the interest on your student loan starts being charged on the first day your lender disburses your loan.

Many students postpone payments while they’re in school and for six months after they graduate. But during this grace period, interest is typically accruing on your student loan. When your grace period ends, this unpaid interest gets tacked on to the total loan amount. Then, interest charges start accruing on this new, bigger total.

This is the “interest on your interest” mentioned above, and it can significantly increase your costs of borrowing. Here are some questions to answer to get a handle on this important issue:

How much does capitalized interest cost?

The cost of capitalized interest will vary depending on your loan amount and terms. A large loan balance, high interest rate and long period of deferment can all increase your capitalized interest costs.

Consider the following example: You borrowed $40,000 at a 5% interest rate on a 10-year repayment term. If you don’t pay any interest during four years of college, your loan will accrue $8,000 in interest.

Assuming the interest is capitalized when repayment starts, your new balance will be $48,000 when you graduate. Over 10 years of repayment, you’ll pay $21,094 in total interest charges.

But what if you made interest-only payments while you were in school? Your student loan balance upon graduation would be the same amount you borrowed ($40,000).

Over 10 years, you’d pay $18,911 in interest on your loans. That’s $2,183 less than the amount you’d pay if you didn’t cover interest while in school.

What’s more, your monthly payments on that lower balance would be $424. But if all the interest is capitalized, your monthly payments would be $85 higher at $509 per month.

What causes interest to capitalize?

There are different ways capitalized interest on student loans occurs. Usually, interest gets capitalized when you leave a grace period, deferment or forbearance, switch to a different repayment plan or take out a direct consolidation loan.

However, the details and conditions of interest capitalization differ depending on whether you have a subsidized or unsubsidized loan, are on an income-based repayment plan or have a federal or private student loan.

Federal subsidized loans

• Federal direct subsidized loans are available to students with financial need.
• With a subsidized loan, the government pays the interest while you’re in school at least half time. As a result, there is no capitalized interest on student loans when you graduate.
• It also pays your interest during your grace period, which is typically six months after you leave school (except for direct subsidized loans disbursed between July 1, 2012, and July 1, 2014). So here, too, you likely won’t need to worry about capitalized interest.
• The government will also pay the interest accrued during a period of deferment (a postponement of loan payments during certain qualifying periods), also avoiding capitalized interest.
• During forbearance — another type of postponement for your loans — your loan will accrue interest, and this will capitalize, unless you have a Perkins loan. (Note that no federal student loans accrued interest during the emergency forbearance period put in place in response to the 2020-21 COVID-19 pandemic.)
• If you combine your loans under a direct consolidation loan, any unpaid interest will capitalize.
• If you join certain income-driven repayment plans (including PAYE, REPAYE and income-based repayment) and then exit the program or no longer qualify, interest can capitalize. Check the Federal Student Aid site for details on each plan’s interest capitalization.

Federal unsubsidized loans

• Federal unsubsidized loans, including the direct unsubsidized loan, are available regardless of need.
• With an unsubsidized loan, interest will accrue while you’re in school and during the grace period. You aren’t required to make payments during this time — however, if you don’t, the interest will capitalize when your loan enters repayment.
• During deferment or forbearance, your loan will accrue interest, which, if unpaid, will capitalize when payments resume.
• As with subsidized loans, if you combine your loans under a direct consolidation loan, any unpaid interest will capitalize.
• If you join certain income-driven repayment plans (including PAYE, REPAYE and income-based repayment) and then exit the program or no longer qualify, interest can capitalize.

Private loans

• Private student loans are available regardless of need. You or your cosigner must meet a lender’s credit and income requirements to qualify.
• Just like with federal unsubsidized loans, interest will usually accrue on private loans while you’re in school and during any grace period (not all private lenders offer these). You may or may not need to make payments during this time, depending on the lender, but if you don’t, the interest will capitalize when your grace period ends.
• Deferment and forbearance aren’t usually offered with private student loans, but when they are, your loan will often accrue interest that, if unpaid, capitalizes at the end of these periods.
• Private loans do not include access to federal income-driven repayment plans.

How can you avoid capitalized interest on student loans?

Regardless of the type of loan you have, if you’ve accrued interest by the time that you’re required to begin making payments, you have options to avoid capitalized interest on your student loans:

• Pay the accrued interest in full when you start making payments after leaving school, after a grace period or when you exit deferment or forbearance. Of course, this can be difficult to do, depending on your income, the overall loan amount and the amount of interest you need to pay off.
• If you’re not required to make payments during school or the grace period, or for another reason (such as deferment), you could still make small payments to cover the interest. To do this, you may need to track down your student loan servicer and keep track of how much interest is accruing on your loan. This, too, can be financially challenging, though it will likely save you money in the long run.
• Try to limit your student loan borrowing to subsidized federal loans. This may or may not be possible, depending on the cost to attend your school and how much aid you qualify for.
• Finally, avoid changing your student loan repayment plan more often than is necessary, as doing so could trigger interest capitalization.

Can you deduct capitalized student loan interest?

While capitalized student loan interest can increase your costs of borrowing, there is one silver lining: You can deduct capitalized student loan interest on your taxes.

The student loan interest deduction lets you deduct up to $2,500 of the student loan interest you paid in the last year from your taxable income.

Unlike a tax credit, you won’t get this money back; rather, the deduction reduces your amount of taxable income.

As long as you paid student loan interest in the past year, whether capitalized or not, you can claim this deduction on your tax return.

Why is capitalized student loan interest a big deal?

When it comes to student loans, capitalized interest can become a huge financial burden if left unchecked. The more frequently that interest is added to the current principal, the more interest you will pay.

If you know you won’t be making student loan payments for a period of time — whether it’s because you’re in school or you’ve been granted deferment — be aware of whether interest is piling up and have a plan for how to deal with it.

Another strategy for lowering your interest costs is refinancing your student loans for a better rate. If you can qualify for a lower interest rate, you could lower your overall costs of borrowing. But be careful about refinancing federal loans, as doing so means you’ll lose access to federal benefits, such as interest subsidies.

It’s important to understand interest capitalization and what it can do to your loans — that way, you’ll know how to handle it when it’s your time to start repaying your student loans.