Capitalized Interest Fattens Student Loans
Some of the same student loan features that add financial flexibility for students/parents can end up costing extra money in the end, because of capitalized interest. Deferments – the ability to pause loan payments for up to three years to accommodate things like in-school enrollment, unemployment, military deployment, and financial hardship – can be helpful in the short term, but the accrued interest that builds up during the deferment period can sometimes be capitalized and added to the loan balance.
Similarly, a general forbearance, which pauses loan payments for up to a year if you’re having financial difficulties, almost always results in capitalized interest. Forbearance should not be confused with “forgiveness” – for more on that, read “What is Student Loan Debt Forgiveness?”
During 2019, 3.4 million federal loans were in deferment and 2.7 million were in forbearance.1 Since then, a moratorium on student loan payments and capitalized interest has been in effect due to the COVID-19 pandemic and is set to expire on August 31, 2022. Federal loans can be subsidized or unsubsidized; one of the main differences is the government pays the capitalized interest in a subsidized loan and you pay it in an unsubsidized loan. Additionally, private loans can differ in their treatment of capitalized interest.
Since grace, deferment, and forbearance periods are so common, let’s look at an example of how capitalized interest can make your student loan grow larger.2
- If you borrowed $5,000 per year for four years at an interest rate of 5% and took a six-month grace period after graduating, your principal would be $20,000 and the accrued interest that built up over the 4½ years would be $2,937.
- That accrued interest is capitalized at the end of the grace period, making the new balance you owe $22,937 – and going forward you will be charged interest on that entire balance. The extra interest on the higher balance is $31 per month, or an extra $802 over the life of the loan.
There are several online calculators that can help you understand the amount of capitalized interest and additional costs you would incur by pausing payments for your student loan. But you can also avoid paying capitalized interest on your loan in one of two ways:
- Pay off the accrued interest before it capitalizes. Typically, your lender will send you a notice about how much interest will be capitalized at the end of your grace/deferment/forbearance period and the date on which that capitalized interest will be added to your principal balance. By paying it before that trigger date, you can avoid the extra interest costs on the capitalized interest.
- Make interest-only payments. Another option is to make interest-only payments on your student loan during any period that your loan is accruing interest, like when you are in school. If this is feasible, you will need to contact your lender to make special arrangements for interest-only payments.
