Capitalized Interest on Student Loans: How Does It Work?

If you borrowed a student loan to pay for college, one of the most important factors you probably considered when choosing your loan was the interest rate. An interest rate is the percentage of the principal charged by the lender when you borrow money. A lower interest rate is better, as it means you'll need to repay less money than if you had a higher interest rate. But even with a low interest rate, most borrowers will still end up paying back more money than they originally borrowed. Part of this is because of interest capitalization.

Interest capitalization happens after a period of non-payment on a student loan. These non-payment periods include grace periods, forbearance, or deferment. During these periods, the interest is still accruing on your loan even though you are not making loan payments. Once these periods end, the interest capitalizes, which means it is added to your principal loan balance. From then on, your interest is calculated based on that new, larger principal amount. This means that you'll be paying more money over the life of the loan.

For example, say you borrow a $10,000 student loan with an interest rate of 6.8%. The amount of interest that accrues per day is $1.86. If you defer your loan for six months and you do not pay off the interest as it accrues, the loan will accrue $340 in interest. When you end deferment, the accrued interest of $340 will capitalize, meaning your principal balance will now be $10,340. This will cause the amount of interest that accrues per day to increase to $1.93. While this may not seem like a lot, it can add up over time and could increase your monthly payment amount.

So what can you do to avoid interest capitalization? You can pay the interest on your loans while you are in school or during forbearance or deferment periods. Your loan servicer can help you if you are unsure how to do that. Even if you are unable to pay the full amount of interest that accrues every month, just paying some will help lower the amount of interest that will capitalize at the end of the non-payment period.

Do keep in mind that the one exception to this principal is the Federal Direct Subsidized Student Loan, on which no interest accrues while you're in school at least half time, during your grace period, or during any period of deferment.

If you need additional guidance around student loans or repayment, reach out to MEFA's college planning representatives at (800) 449-MEFA (6332) or collegeplanning@mefa.org.

Learn more about managing student loans