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 on your student loans!
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 answer the question, what is capitalized interest, and how does it work? Plus some key steps you can take to minimize how much of it you pay!
What is capitalized interest?
So, what is capitalized interest, and why should you avoid it? In simple terms, capitalized interest is when unpaid interest is added to the principal balance of your loan.
When you take out a student loan, you have to pay to borrow that money. Which 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 by the interest rate. And the amount of time you take to repay the student loan payments.
You can certainly control how much you borrow and how long you take to pay off your loans. However, keep in mind that your monthly payments increase dramatically if the interest capitalizes. Which can make paying it back a lot more challenging.
Having an increased principal increases the total amount you have to pay back over time - thanks to the effects of compounding on that principle and interest Yup, capitalized interest compounds!
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.
Capitalized interest vs accrued interest
So, there's capitalized interest and accrued interest. They're related but not the same.
Capitalized interest is the accrued interest that your lender adds to your principal amount when the interest goes unpaid.
Accrued interest is interest that increases with time, so it's how much interest has grown with your loan since your last payment, but you haven't paid it yet.
If you don't pay the interest on your loan as it accrues, then your lender can add the accrued interest to the principal. For instance, your student loan interest could be accruing while you are in school. So it may not feel like an immediate effect.
Examples of capitalized interest vs accrued interest
As a capitalized interest example, let's say you take out a student loan for $20,000 at 5.8% for 10 years. You defer payment through 4 years of college and the six month grace period.
The interest accrues and capitalizes, and now what was $20,000 is over $32,000 over a ten year repayment period, or even more with fees. The capitalized interest alone would be over $5000.
But accrued interest happens when your loan interest is not paid, and then the interest builds up. It can then be capitalized, creating financial hardship in some cases.
Interest capitalization can impact your life in the long term, making it harder to accomplish your other financial goals if you have the addition of unpaid interest. 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 capitalization on your student loans can happen for a number of different reasons. We'll discuss another capitalized interest example in a moment. Capitalized interest usually relates to a period of time when you don’t pay your loans. With federal loans, it occurs when:
- The grace period of your unsubsidized loan ends
- During forbearance or after a period of deferment
- When you leave an income-based repayment plan like Pay As You Earn (PAYE)
- When you consolidate your loans
As a capitalized interest 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 it's the end of the grace period, six months 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. And capitalized interest on student loans will definitely increase your payments.
With the average total cost of a four-year college costing around $141,000, it’s likely that you will need to take out some student loans. While interest capitalization does occur sometimes, there are a few things you can do to not have to deal with avoidable interest.
Pay your student loans while in school
If you’re able to, start paying off your student loans while you are still in school. Your education is a long-term asset, and student loans may help you to obtain your degree.
But at the very least, try to pay off any interest on unsubsidized loans. It will help you lower your total loan balance, as the interest isn't 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. Using such information to make as many extra payments as possible will ultimately lower your student loans and allow you to focus on your other financial goals.
That said if you find that you are able to make any extra payments while in school, doing so can only help with capitalized interest. If you begin to make extra money from a job or find that you have some cash available, using it for student loan repayment is a smart decision.
Pay tuition without student loans
While it isn't always possible for every situation if you can, try to avoid student loans altogether. Instead, use grants, scholarships, and work-study to pay for school. Researching alternatives to loans prior to going to college may be helpful.
You may also choose to work full-time and go to school over a longer period of time. Or work part-time and split your time between work and school. If you're able, avoiding student loans is the best way to not have to deal with any actual interest from loans.
Use passive income to get ahead
While you might be quite busy with your classes for the next few years and focusing on your studies is important, you can still make money. Passive income can be a great alternative to working a job while in school full-time.
There are a lot of passive income ideas for students that you can try out to help your financial situation and get rid of student loans and interest.
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 interest capitalization. Pay off your loans as often as you can to help with this.
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. It can help you decide if it’s worth letting the interest pile up.
Capitalized interest and student loans are manageable with some preparation
Most of us dread student loans. And now you've seen a capitalized interest example and know how it works.
It may seem challenging to avoid this, though. But with a little bit of guidance 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.