If I could give one piece of advice to every person with student loans, it would be this: beware capitalized interest!
Most people understand that interest accrues whenever you take out a loan and doesn’t stop until the balance goes to $0. The more interest you accumulate, the more expensive it’s going to be for you to pay back the loan and get on with your life.
The following factors determine the amount of interest:
- Principal balance of the debt
- Interest rate
- How the lender calculates interest
- How often interest gets added to the loan
Simple interest, compound interest, and capitalization
There are typically two ways a lender can charge interest – simple interest and compound interest.
When a loan uses simple interest, the lender takes the principal balance and multiplies that amount by the interest rate to determine additional charges. For example, let’s say you take out a $10,000 loan at a 5% interest rate. Each year, you’ll get charged $500 in interest until you start to pay off the principal balance. If you don’t pay down the principal, interest continues to accrue at a rate of $500 per year.
Compound interest is interest calculated on the amount of the loan plus any accumulated unpaid interest from previous periods. When you don’t pay enough to cover the interest, the lender adds that amount to the principal balance. Additional interest will now be calculated based on the total amount left over – effectively causing you to pay “interest on interest.”
To illustrate, let’s go back to our example of a $10,000 loan at 5% interest with one payment due each year. If you pay $500 in Year One, your loan will accrue $500 in interest in Year Two – just like simple interest. If, however, you pay $250 in Year One, then there will still be $250 in unpaid interest on the loan. Under compounding, that shortfall will be added to the principal balance so that $512.50 in interest will get added in Year Two ($10,000 + $250 = $10,250 x 5% = $512.50).
The process of compounding interest is called capitalization.
When does interest on Federal student loans capitalize?
For federal student loans, interest capitalizes in the following situations:
- At the end of periods of forbearance.
- When deferment ends on an unsubsidized loan. The government pays all interest that gets added on subsidized loans during periods of deferment (including the in-school grace period). Interest on unsubsidized loans, however, will be capitalized at the end of deferment.
- When you consolidate your federal student loans.
- If you get your loan out of default through rehabilitation.
- If you either leave or fail to recertify your income for participation in Revised Pay as You Earn (REPAYE). This Income-Driven Repayment (IDR) Plan comes with forgiveness of some of the interest that accrues each month, so there will be a smaller amount to capitalize.
- If you’re in Pay as You Earn (PAYE) or Income-Based-Repayment (IBR) capitalization occurs if you don’t recertify your income, exit the plan, or if your income increases beyond a certain threshold.
- If you are repaying your loans under Income-Contingent Repayment (ICR), interest capitalizes every year.
When does interest on private student loans capitalize?
Federal regulations don’t govern the repayment terms on private student loans. To fully understand how compounding and capitalization affect your loan, read the loan terms carefully. In general, most private student loans provide for capitalization of interest:
- At the end of the grace period;
- After a period of deferment or forbearance; and
- When the note goes into default.
Many private student loans compound interest daily in the same way the credit cards operate. Under daily compounding, interest accumulates each day based on the total outstanding balance rather than keeping principal separate from interest at the end of each day, month, or year. This form of compounding causes the balance on your private student loan to increase much more quickly than a federal student loan with the same principal balance and interest rate.
Should you pay off interest before it capitalizes?
It’s a no-brainer to pay your private student loan interest before it capitalizes because these debts don’t come with any mandatory paths to forgiveness or discharge. For federal student loans, however, the answer isn’t as clear. Before sending the money to your servicer, ask yourself these questions.
- Is the loan subsidized? Remember, the government pays the interest that accrues on subsidized federal student loans during periods of deferment. You shouldn’t ever pay the interest on a subsidized loan at the end of a deferment.
- Are you heading towards Public Service Loan Forgiveness (PSLF)? When you get your federal loans forgiven under PSLF, the unpaid balance is wiped out. You aren’t required to pay income tax on the remaining balance, and there’s no cap on the amount you can get wiped out with PSLF.
- Are you paying your loans under REPAYE or IBR? Under both REPAYE and IBR, the government pays part of your student loan interest every month.
- If you’re in an IDR plan, when will forgiveness occur? All of the IDR plans come with forgiveness of your unpaid federal student loan balance, but it may be considered taxable income. Sit down with a student loan planning advisor to understand the amount likely to be forgiven and your potential additional tax burden. Once you’ve done that, you can decide whether you benefit more by investing your extra cash or using it to pay down the accrued interest.
- Do you qualify for another type of tax-free student loan forgiveness? PSLF isn’t the only type of federal student loan forgiveness that doesn’t come with a tax bomb. Certain employers provide benefits that include student loan repayment and discharge options such as those available to borrowers who are totally and permanently disabled are tax-free.
Use interest capitalization to your benefit
You can avoid capitalized interest on student loans by paying the interest that accrues while you’re in school and during periods of forbearance and deferment. The question, however, is more about the impact of capitalized interest as opposed to avoiding it altogether.
If capitalization isn’t going to harm you financially, there’s no sense in stressing over it. It’s all a matter of understanding the rules of the student loan game so you can use them to your financial advantage.
Talking with an attorney who understands student loan regulations can provide you with the insight and knowledge to make the best choice. Some financial planners also have experience helping student loan borrowers plan for their financial future. Finally, the U.S. Department of Education has a ton of information available on its website. Whatever road you choose, it’s up to you to be fully informed so you can make decisions that maximize your benefits over the long haul.