Raise your hand if you'd like to increase your student loan balance. Yeah, I didn't think so.
Unfortunately, many borrowers do exactly that without realizing it when they take advantage of federal programs like income-driven repayment plans, forbearance or deferment. Why? Interest capitalization.
What is interest capitalization?
Your student loans begin accruing interest the day they're disbursed. So the day you start college, your loans are already accruing interest. And they continue to do so over the next four years.
Let's go back in time for a moment ... back to when you first started college: You're not making any payments on your loans because you're in school and enjoying the grace period that a federal loan servicer offers students. You're in a happy little bubble.
But once you've graduated ... pop! Your loan servicer takes all the interest that accrued during those four years and adds it to your loan balance. That new, higher number becomes your new loan balance.
That's interest capitalization.
Of course, if you had a federal subsidized loan, the federal government paid that interest for you during those four years. But if you had an unsubsidized loan or a private loan, the interest that accrued unpaid during that time will be capitalized at the end.
What triggers student loan interest capitalization?
Interest can also be capitalized if you're making payments, but they're not large enough to cover the full amount of interest accrued.
If you're making payments through an income-driven repayment plan for a federal loan, interest is capitalized after certain triggering events, such as:
- Failing to meet a "financial hardship" requirement
- Leaving the repayment plan, or
- Failing to submit the documentation required to remain in the program.
If you have a private loan, interest is capitalized every month you have unpaid interest.
How does interest capitalization affect your student loan payments?
So let's say you have $60,000 of federal unsubsidized student loans from your undergraduate degree. You get into an awesome graduate program, and you apply to have your undergrad loans deferred because that's one of the benefits of having federal loans. Woohoo, you're thinking. No more student loans for two years!
You finish your grad program, and you get your first bill from your loan servicer. The debt balance that used to be $60,000 is now $68,160, and they're saying it's all principal. How did that happen? Well, you were accruing interest at 6.8% for two years, and right before they took you off deferment, your lender capitalized the interest.
Now, instead of future interest being calculated based on a $60,000 balance, it will be calculated on a $68,160 balance—meaning your monthly payments may go up. And it'll take you longer to pay off the debt.
In short, interest capitalization is not your friend.
How can you avoid interest capitalization?
Unfortunately, there's no magic trick for avoiding interest capitalization. But there are a few things you can do to reduce the chances that you'll be staring at an unexpectedly large loan balance.
1. Pay the interest
If you defer your loans, consider continuing to make interest payments during the deferment or forbearance period. Even if you can't pay the full amount, small additional payments throughout will help to reduce the interest that gets capitalized.
If you have the funds, you can also pay the interest in one lump sum near the end of a grace period before it capitalizes.
If you're on an income-driven repayment plan, check to see whether you're paying enough to cover the interest every month. If you're not and you can afford to pay a little more, do so. Even if you're only able to make small sporadic payments, those will help reduce the total interest accrued. (However, if you're banking on taking advantage of any form of student loan forgiveness, it's best not to pay any more than you have to.)
2. Make strategic loan decisions
If you're able to choose federal subsidized loans when you're borrowing, you'll benefit from the government making your interest payments during a grace period. If subsidized loans aren't an option, a good rule of thumb is always to take out the smallest amount you need to cover your costs.
3. Refinance your student loans
Yes, that bigger loan balance is hard to stomach, but you don't have to be stuck with those monthly bills until you retire.
Refinancing your student loans could lower your interest rate, meaning you could actually end up paying less over the life of the loan. In fact, the average borrower who refinances their student loans saves approximately $16,183 over the life of the loan.
See how much you could save.