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The total amount you pay for your student loan can significantly increase with capitalized interest.
Capitalized interest is unpaid interest added onto your loan balance after periods of nonpayment.
You may consider making interest-only payments while in school to lessen your cost afterward.

What capitalized interest means

While student loans can be a worthwhile option to fund your education, the money you pay in interest can quickly add up and make the total cost of your loan far exceed the initial amount you borrowed. Make sure you understand what you're getting into with capitalized interest on your student loans.

Capitalized interest is any amount of unpaid interest on a loan, added to the existing remaining balance. The interest is added to the principal, where instead of just paying interest on the original loan amount, you start paying interest on the accumulated interest too.

Capitalized interest can become stressful if left unpaid for too long. Your loan balance will increase, and any future interest is calculated on that larger amount, which leads to a snowball effect.

When capitalization typically happens with loans

Capitalization tends to happen within three circumstances: during deferment or forbearance, after a grace period, or through missed or defaulted payments.

In deferment or forbearance with subsidized student loans, the government covers the interest for a set amount time. This is not the case with unsubsidized loans. Some loans have a grace period before repayment starts. Unsubsidized loans may capitalize any unpaid interest at the end of this period. Missed or defaulted payments can trigger capitalization on certain loans.

An example

Assuming you take out a $20,000 loan at a 5% interest rate. In this scenario, you have a standard 10-year repayment term, and you are not required to make payments during four years of college and a one-year grace period.

In the following table, we are comparing how much you would pay if you deferred payments for four years of school and the grace period versus if you made interest-only payments during this time.

	Deferred payments	Interest-only payments
Loan amount borrowed	$20,000	$20,000
Interest accrued over five years	$5,000	$0 ($5,000 paid in interest)
Loan balance when repayment begins	$25,000	$20,000
Total paid over 10-year term	$31,820	$30,456

The difference between deferred payments and interest-only payments over this 10-year term is $1,364. Capitalized interest can get expensive fast, so try to avoid it if at all possible.

You'll also pay less per month once repayment begins if you made interest-only payments while in school and during your grace period, because you're making payments on a smaller loan balance. You'd pay $265 per month after deferred payments, while you'd pay $212 per month after interest-only payments.

Why capitalized interest matters

Capitalized interest matters for two main reasons.

The first is that it will cost you more in the long run and you'll end up paying interest on top of interest, which significantly increases your total debt.

The second reason is that it raises your monthly payment. Since your principal is larger after capitalization, your monthly payments will go up.

Interest on private student loans

You may be able to request forbearance from your private lender, but unlike federal loans, interest will likely still accrue while your payments are on hold. Private student loans generally come with higher interest rates than federal student loans.

Private lenders usually offer either three or four repayment plans, which are as follows:

Deferred: You won't make any payments while in school or during a grace period, but interest will accrue and capitalize once payments begin. This is the most expensive option overall.
Fixed: You'll pay a set amount each month toward your loan. Unpaid interest will accrue and capitalize after your grace period.
Interest-only: As the name suggests, you'll make monthly interest payments.
Full: You'll begin making payments on your principal and interest immediately. This is the least expensive option because you aren't allowing interest to accrue and are actively paying down your balance at the same time.

Before you decide to defer your student loan payments until your grace period is up, consider how capitalized interest might substantially increase the cost of your borrowing.

Interest on federal student loans

The interest on Direct Subsidized Loans will be paid by the government while you're in school and during your six month grace period, so you won't have to worry about interest capitalizing on your loan during with federal forbearance.

However, if you begin paying down the balance on your loan before your grace period is up, you'll still pay less in overall interest. Why? Because your starting loan principal will be lower when you need to start paying interest.

The difference between a 5% interest rate on a $10,000 balance versus on a $5,000 balance might not seem like a lot, but over a 10-year repayment period, you'd pay roughly $1,400 more in interest alone on the $10,000 balance.

FAQs

Ryan Wangman, CEPF

Loans Reporter

Ryan Wangman was a reporter at Personal Finance Insider reporting on personal loans, student loans, student loan refinancing, debt consolidation, auto loans, RV loans, and boat loans. He is also a Certified Educator in Personal Finance (CEPF).In his past experience writing about personal finance, he has written about credit scores, financial literacy, and homeownership. He graduated from Northwestern University and has previously written for The Boston Globe.