Let’s start with the basics: If you have a student loan, you are being charged interest on the money you borrowed.
It doesn’t matter if it’s federal, private, subsidized, unsubsidized or sud-sized (OK, that last one isn’t a thing but consider it a clean joke).
The feds will cover the interest on your subsidized loan up until graduation, but every other loan is accruing debt from the moment you sign for it.
That interest gets lumped onto your total — known as interest capitalization — unless you pay it off first. Doing that could save you wad of dough. Here’s how.
What Is Interest Capitalization?
To understand interest capitalization, you need to know a little more about your loan.
When you see your student loan balance, it will be listed in two parts: principal balance and interest balance.
“The reason they’re separate is because the interest does not itself generate additional interest — which is good,” said Heather Jarvis, a North Carolina attorney who specializes in student loans. “It’s different than it is with a lot of kinds of other consumer credit.”
Private student loans vary, so check out the terms for an interest-only payment option. Some lenders offer special discounts for students willing to pay their interest while still in school.
So unlike credit cards, student loans only accrue interest on the principal amount, and you can pay off that interest separately from the principal until a specified time period or event. With federal student loans, that time is the six-month grace period after graduation before you have to start making loan payments.
After that, all of the accrued interest gets added to your principal. That’s interest capitalization. And at that point, you continue accruing interest on the new higher total — also known as compound interest.
How Does Interest Capitalization Affect My Student Loan?
It’s easiest to explain how interest capitalization works with an example.
Let’s say Jane and Joe each take out $5,000 in federal unsubsidized student loans at an interest rate of 6% for every year of school. After four years, they graduate having borrowed $20,000 and each have a six-month grace period on their loans.
Each year of college, they accrue $300 in interest ($5,000 x 6%). Multiply that interest amount by the number of years until graduation:
Freshman: $300 x 4 years = $1,200
Sophomore: $300 x 3 years = $900
Junior: $300 x 2 years = $600
Now add the interest accrued on the principal during their six-month grace period: $20,000 x 6% = $1,200 / 2 (because it’s half a year) = $600
Total Interest: $3,600
Jane uses those six months after graduation to build her savings and pays off the $3,600 in interest just before her grace period expires. Joe … doesn’t.
As a result, Jane’s total principal remains $20,000. The $3,600 on Joe’s loan is capitalized and his new total stands at $23,600. Both will begin accruing interest on their totals, but because he’s starting with a higher balance Joe ends up paying a lot more.
Over the life of a 10-year payment plan, Jane will pay $222 per month for a total of $26,645, while Joe will pay $262 per month for a total of $31,441.
Jane saved $40 per month and $1,196 over the course of her loan, compared to Joe, by paying off her accrued interest before her grace period ended, thus avoiding interest capitalization.
When Does Interest Capitalization Occur?
For federal student loans, interest capitalization occurs for any of the following events:
- When the loan enters repayment (aka when the grace period ends).
- When a period of forbearance or deferment ends.
- When the loan is consolidated.
If you’re on an income-driven repayment plans, you’ll have additional restrictions. For Income-Based-Repayment (IBR), Pay as You Earn (PAYE) or Revised Pay as You Earn (RPAYE) plans, interest capitalization also occurs for any of the following:
- If you leave the payment plan.
- If you no longer qualify for the plan.
- If you don’t recertify your income each year.
If you’re on the Income-Contingent Repayment plan, your interest will capitalize annually.
With all income-driven repayment plans, you must resubmit your income and family size every year to determine eligibility. Married couples will have to submit their combined income.
And here’s the kicker about income-driven repayment plans. The lower payments that they offer may not fully cover all of the interest that’s accruing, leaving you to pay more in capitalized interest.
Interest capitalization depends on a number of factors in regards to income-driven repayment plans — subsidized loans are eligible for interest subsidies, for instance — so review your specific repayment plan agreement for details about interest accrual.
How Can I Avoid Interest Capitalization — or at Least Reduce It?
Paying off your interest before any of the triggering events is the only way to completely avoid interest capitalization.
However, even if you can’t pay off the entire amount, any money you can put toward your interest before the triggering event will will save you money.
We kept things simple for our example, but your interest rate will probably be different for each loan. Paying off the interest on the loans with the highest rates first can help you save money (it’s known as the debt avalanche method).
If you’re still in school, ask your lender about making interest-only payments so you can reduce the total interest that accrues before you graduate. You can also make interest-only payments during forbearance or deferment.
And if you’re a recent graduate and still within that grace period, now is the time to put as much money as you can toward paying down that interest. We have plenty of ways to make extra money, whether it’s working side hustles, selling stuff online or doing nothing.
After all, it’s in your best interest. (Sorry, couldn’t help myself.)
Tiffany Wendeln Connors is a staff writer/editor at The Penny Hoarder. Read her bio and other work here, then catch her on Twitter @TiffanyWendeln.