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Interest is no fun unless you are earning it. When you have to pay it, it can be a major hindrance. For instance, capitalized interest.
Capitalized interest on student loans ultimately increases the amount of money you have to pay back. If you want to avoid paying more than you borrow, it’s best to avoid this type of interest.
So let's get into what it is exactly, how it works, and some key steps you can take to minimize how much of it you pay!
What is capitalized interest?
When you take out a student loan, you have to pay to borrow that money. This payment is what we call interest. It’s also the cost of the loan. The total cost you pay is determined not just by how much you borrow, but also the interest rate and the amount of time you take to repay the loan.
You can certainly control how much you borrow and how long you take to pay off your loans. However, keep in mind that if the interest is capitalized, your monthly payments increase dramatically.
Essentially, capitalized interest is when unpaid interest is added to the principal balance of your loan. Having an increased principal increases the total amount you have to pay back over time thanks to the effects of compounding on that principal and interest. Yup, capitalized interest compounds!
If the interest on your loan is not paid as it accrues, then your lender can add it to the principal. For instance, your student loan interest could be accruing while you are in school. Because your principal is higher, you’ll end up paying more in interest. You can end up in a cycle of debt, taking even longer to pay off your student loans.
This can impact your life in the long term, making it harder to accomplish your other financial goals.
After all, it’s difficult to buy a house or save for retirement when you have tens of thousands of dollars of student debt looming over you.
How does interest capitalize on student loans?
Interest on your student loans can capitalize for a number of different reasons. All of which usually relate to period of time when you don’t pay your loans. Capitalized interest on federal loans occurs when:
- The grace period of your unsubsidized loan ends
- During forbearance or after deferment
- When you leave an income-based repayment plan like Pay As You Earn (PAYE)
- When you consolidate your loans
For example, let's say you take out an unsubsidized student loan over four years for $27,000 with an interest rate of 4.53%. After your four years are up and your six month grace period ends after you graduate, you will have $3,511 in unpaid interest.
That means while you thought your loan was only $27,000, it’s now $30,511.
How can you avoid capitalized interest on student loans?
No one wants to pay more than they have to. With the average total cost of a four-year college costing around $122,000, it’s likely that you will need to take out some student loans. While sometimes capitalized interest is unavoidable, there are a few things you can do to avoid it.
Pay your student loans while in school
If you’re able to, start paying off your student loans while you are still in school. At the very least, try to pay off any interest on unsubsidized loans. This will help you lower your total loan balance, as the interest will not be added to your principal when you graduate.
Make extra payments
While it might not be possible to pay off your loans while you are still in school, you can make extra payments later on. Making as many extra payments as possible will ultimately lower your student loans and allow you to focus on your other financial goals.
Avoid paying more than you have to in capitalized interest
If you want to become debt-free and pay off your student loans, one of the things you can do is avoid capitalized interest being added to your student loans. Pay off your loans as often as you can.
If for some reason you need to pause payments, you can use a student loan calculator to find out how much you will owe if you let the interest capitalize. This can help you decide if it’s worth letting the interest pile up.
Most of us dread student loans. But with a little bit of help and planning, you can pay off your student loans in no time.
Want to learn more? Check out our free 3-course bundle on how student loans work.