Interest is no fun unless you are earning it. When you have to pay for it, it can be a major hindrance. It’s even worse when you have capitalized interest that starts to compound. So how do you avoid that? Keep reading to learn more about how capitalized interest works and how borrowers can avoid it or pay it off on their student loans.
What is capitalized interest?
In simple terms, capitalized interest is when unpaid interest is added to the principal balance of your loan and then your lender charges your existing interest rate on the new, higher balance.
Essentially, your outstanding interest charges are added to your total loan balance—and interest is charged on the higher balance. Student loans are among the most common places to find a capitalized interest example.
Capitalized interest student loan costs can greatly increase the total cost of a loan. If you want to avoid paying more than you borrow, avoiding this type of interest is best.
How capitalized interest works on student loans
Let’s start with how a student loan works. When you take out a student loan, you’re charged interest. The interest charges are essentially the cost of the loan, as most lenders won’t let you borrow money for free!
The total cost you pay for a loan is determined not just by how much you borrow but also by the interest rate. A higher interest rate will increase the overall cost of a loan.
Additionally, the time you take to repay the student loan will affect your total costs.
Capitalized interest on student loans can further increase overall costs. As interest increases, your monthly payment goes up, making it even harder to pay back your loans.
An increased principal increases the total amount you must pay back over time. Thanks to the effects of compounding on that principal and interest. Yup, it’s one of the examples of compound interest!
Capitalized interest vs accrued interest
You might be wondering if capitalized interest is the same as accrued interest. While they’re related, they’re not the same.
Capitalized interest is the accrued interest that your student loan lender adds to your principal amount when the interest goes unpaid.
Accrued interest is interest that increases with time. Essentially, it’s the amount of interest that has grown since your last payment, but you haven’t paid it yet.
If you don’t pay the interest on your loan as it accrues, your lender can add the accrued interest to the principal, resulting in capitalization.
For instance, interest could accrue while you are in school. Thanks to deferment periods, you don’t have to pay it back until you graduate.
However, this means your lender can add your unpaid interest to your total loan balance at the end of the deferment period. They can also charge you interest on the new balance.
Capitalized interest example
As a capitalized interest example, let’s talk about it works on student loans work. Say you take out a student loan for $20,000 at 5.8% for ten years. You defer payment through 4 years of college and a six-month grace period.
The interest accrues and capitalizes, and now $20,000 is over $34,000. It’s likely to be even more when you factor in fees. The capitalized interest alone would be over $7000.
Interest can impact your life in the long term. It can make it harder to accomplish your other financial goals if you have the addition of unpaid interest. In my experience, getting out of debt is much harder than avoiding it in the first place.
Expert tip: Don’t skip over reading your loan agreement
Interest capitalization can happen on both federal student loans and private loans. To avoid it, be sure to carefully read your loan agreement so you know when interest will be capitalized. Do this regardless of whether your loan is federal or private.
How do you end up with a capitalized interest student loan?
Interest capitalization on your student loans can happen for several different reasons. Generally, interest capitalizes after a period of not paying the loan’s balance.
With federal loans, interest capitalizes when:
For example, let’s say you take out an unsubsidized student loan over four years. The loan is for $27,000 with an interest rate of 4.53%. After your four years are up and the end of the grace period, six months after you graduate, you will have thousands of dollars in unpaid interest.
That means while you thought your loan was only $27,000, it’s now over $30,000. And don’t forget—you now have to pay interest on that higher balance.
How can you avoid a capitalized interest student loan?
The average cost of a four-year college is around $26,000 a year, according to Education Data Initiative, you might have to take out some student loans to cover costs.
Of course, no one wants to pay more than they have to. Capitalized interest on student loans will definitely increase your payments.
The good news is there are many ways to avoid capitalized interest on your student loans altogether.
Pay student loan interest while you’re in school
Your education is a long-term asset, and student loans may be necessary to help you earn your degree. However, that doesn’t mean your loans should define your future. If possible, start paying off your student loans while you are still in school.
Not everyone can afford to make loan payments while in school. This is why loan deferment and post-graduation grace periods exist.
However, one of the easiest ways to avoid capitalized interest is to pay your student loan interest costs even while the loan is deferred. Try to find a way to pay your interest while in school. You can avoid hefty costs when you graduate.
While it might not be possible to pay off your loans while you are still in school, you can make extra payments later. Once you’re graduated and financially secure, you can lower your interest costs by paying down your balance with extra payments.
Paying extra doesn’t necessarily avoid the interest, but it does help reduce your loan balance after adding capitalized interest. The more you can lower your loan balance, the less you’ll pay in interest charges over the life of the loan.
For example, I paid off my last car loan over two years early by making extra principal-only payments every few months, which saved me over $1,000 in interest.
I got the loan with a higher interest rate than I was hoping for, so I knew I needed to be aggressive with repayment to lower the overall cost of my vehicle. Each time I found myself with extra cash, I made an extra payment on the car because I really wanted to get out of my car loan.
Additionally, if you can make any extra payments while in school, doing so can only help. If you begin to make extra money from a job or find that you have some cash available, using it to pay off student loan interest that could be capitalized is a smart idea.
Pay tuition without student loans
If you’re lucky enough to be able to, avoid student loans altogether.
Instead, you can use grants, scholarships, and work-study to pay for school. Researching alternatives to loans before going to college may be helpful.
I was lucky enough to graduate college without any student loan debt, thanks to a combination of education savings and scholarships. I chose a school that offered a range of merit-based scholarships and was known for awarding high-dollar scholarships to students with similar extracurricular resumes and grades to mine.
You may also choose to start working and going to school over a longer period of time.
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.
How does it work?
Passive income generally requires some work to set up. After setting it up, however, your passive income stream generates revenue with little to no work from you.
There are a lot of passive income ideas for students that you can try out, including renting out your car, textbooks, and other belongings. It will help your financial situation and eliminate student loans and interest.
Know when interest will capitalize
Regarding student loan interest, a proactive approach is generally better than a reactive approach. One of the best ways to avoid capitalized interest on your personal balance sheet is to know when interest will capitalize and keep yourself out of those situations.
I suggest contacting your loan servicer or provider and asking them directly what would lead to interest capitalization. Loan agreements can vary, so situations that capitalize interest for a friend might not apply to your loan.
Going straight to the source will tell you when your interest might capitalize.
Additionally, it will tell you how you can stay away from these situations.
Negotiate with your loan servicer
Speaking of reaching out to your loan servicer, you can always try to negotiate your loans with your provider.
Whether you have federal or private student loans, you may be surprised how many interest repayment options might be available to help you avoid capitalized interest. Many providers are especially willing to work with you if you’re struggling financially.
Remember, the worst outcome that can happen is your loan servicer saying no.
Refinance or consolidate loans
A word of caution: refinancing or consolidating your loans may trigger capitalization of outstanding interest. This might not be a big issue if you snag a great rate on your new loan because you’ll save enough to cover the additional balance.
However, if your rate isn’t significantly lower, you may need to pay off outstanding interest before refinancing. Paying the lump sum of your currently owed interest before refinancing means there won’t be any outstanding interest to capitalize when you refinance or consolidate.
Get a part-time job to pay loans
Do you have some extra time around your studies? You may want to get a part-time job to use exclusively to pay your student loan interest. Depending on how much you’ve borrowed, your part-time job may not need to be a huge time commitment to help you avoid interest.
Additionally, a part-time job in your preferred industry (or even an online part time job) could help you land a full-time career after graduation—which in turn helps you avoid deferment and capitalized interest charges.
In college, I knew several people who used their part-time jobs to help pay for college and advance their future careers.
For example, a friend of mine majored in finance and worked part-time as an accounts receivable clerk at a local business.
After graduating, they had both their degree and their part-time work in accounting to help them land a high-paying accounting job. They could immediately start paying their student loans without worrying about capitalized interest from the grace period.
Why am I paying capitalized interest?
You might be paying this cost on your student loans for a few reasons. It’s important to carefully go over your loan terms so you know what triggers will cause interest to capitalize.
Some of the most common reasons you might pay these costs include:
- You’ve reached the end of your post-school grace period.
- You’ve accrued interest during a deferment period or forbearance, which is added to your balance at the end of the period.
- You switched repayment plans, and unpaid interest was capitalized.
- Your income increased, and you no longer qualify for an income-driven repayment plan.
What are the rules for capitalized interest?
The exact rules can vary based on your student loan agreements.
For example, your loan agreement might capitalize interest if you enter a forbearance period. The best way to learn the rules of your loans is to talk to your loan servicer and ask which events will trigger interest capitalization.
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You can minimize your interest costs with some preparation
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.
Student loans are unavoidable for many students, but that doesn’t mean you should have to pay more than you agreed upon. The easiest way to pay off your student loans is to avoid extra costs, especially capitalized interest.
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.
It may seem challenging, but with some guidance and planning, you can avoid capitalization and get to work paying off your principal balance. Want to learn more? Our free 3-course bundle on how student loans work can guide you in the right direction.
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