What is Capitalized Interest?
Capitalized interest is the addition of any unpaid interest on your loan payment being added to the total principal balance of your loan. Loan payments are broken down into two parts, principal and interest. The amount of principal and interest for the payment depends on the length of the loan, the interest rate, and the loan balance. If the loan is being paid down with normal monthly payments, then each and every month the principal portion of the payment increases, and the interest portion of the payment decreases. This can be viewed in an amortization table. When a borrower fails to pay the interest portion of a loan payment during the term in which it is due, the lender will capitalize the interest and increase your principal balance by that same amount. Capitalized interest is the number one reason why people are confused at how their loan balance has grown while making payments for years.
Do Student Loans Have Capitalized Interest?
Student loans do have capitalized interest but the US Government pays the interest on subsidized federal student loans for a certain length of time. For unsubsidized loans, interest generally starts to accrue from the date that the loan is disbursed to the borrower.
When Interest Accrues
| While In School | During 6mo. Grace Period | During Deferment Periods | |
|---|---|---|---|
| Subsidized | No | No | No |
| Unsubsidized | Yes | Yes | Yes |
Repayment Plan Interest Forgiveness
Federal student loans have 6 repayment plans which can be chosen by the borrower depending on their needs. Some of the repayment plans include an interest forgiveness or subsidy. When making income-driven payments, its possible and likely that the payment made is not enough to cover the principal & interest that a normal standard payment would provide for. If the payment made does not cover the principal and interest in total, the payment would first be applied to the interest accruing on the loan, and any remaining amount would go to the principal balance. If the payment is not enough to cover the monthly accrued interest on the loan, then the interest subsidy or forgiveness comes into play. The revised pay as you earn plan has the best interest forgiveness as it covers both subsidized loans, and unsubsidized loans. Here is a chart showing the amount of interest subsidized by the US Government depending on loan type and payment plan.
What is The Difference Between Accrued Interest and Capitalized Interest?
Accrued interest is interest that has been accumulating since your last loan payment, but has not yet been capitalized or added onto the principal balance of the loan. For example, if someone owes $10,000 with an interest rate of 5%, the daily accruing interest would be $10,000 x 5% divided by 365 days. In this case, it would be $1.37/day. If the borrowers last payment was 20 days ago, the accrued interest would be $1.37 x 20 = $27.40. If the borrower fails to make a payment on the loan during the next scheduled payment, or the payment made does not cover the interest, that is when the accrued interest would capitalize and be added to the principal balance of the loan.
Does Capitalized Interest Compound?
Yes, capitalized interest does compound. What this means is that when your student loan balance grows by the unpaid accrued interest that’s been capitalized, the interest is calculated on your new loan balance. This leads to many frustrated borrowers wondering how their balance has grown so significantly and out of control. Compounding interest means that if you allow accrued interest to capitalized, you will be paying interest on the interest of your loan. This is something you want to avoid at all costs, if possible.
How Do I Avoid Capitalized Interest?
Make Minimum Interest Payments
The best way to avoid having the interest capitalized on your loan is to make a payment that at the very least covers accruing interest. As we discussed previously, your loan payment is broken down into both principal and interest. If you make sure to pay the monthly interest on your loan, there would be no accrued interest remaining to be capitalized.
Enroll In a Repayment Plan Designed For You
Another option is to use the federal programs which are designed to assist people in financial need. If your loans are eligible and you are struggling to make your payments, enrolling into the revised pay as you earn plan will remove the interest capitalization for three years, and then cut the amount in half for the remaining term of the loan. This can result in many thousands of dollars being saved on student loan payments. Keep in mind enrolling in an income-driven repayment plan will require you to send a recertification of your income letter annually, or you will lose your payment plan interest subsidy.
For Unsubsidized Loans – Start Paying While Still In School
Since unsubsidized student loans start to accrue interest from the day of the loan disbursement, you should start making payments immediately on your loan. Working part-time while in college to make your payments can go a very long way in helping to keep your student loan balance under control.
Set up Automatic Payments
Lenders don’t care for what reason you missed your payment, they will capitalize the interest. Don’t allow any mistakes to happen either because you are distracted by work, or school. Set your payments to be paid automatically every month to keep your balance from growing.
Is Capitalized Interest Tax Deductible?
Yes, capitalized interest is tax deductible for the year in which you paid it. You can only claim the tax deduction for interest after it’s been paid, not before.
Conclusion
Compounding interest on loans can be very dangerous if the borrower isn’t meeting their monthly obligation on the loan. When interest begins to capitalize on the loan, the balance begins to grow. What happens next, is interest being paid only to pay off interest which was not part of the original money that was borrowed. Borrowers should do everything they can to make sure to pay their monthly accrued interest.
sources:
https://ttlc.intuit.com/questions/2901930-claiming-capitalized-student-loan-interest-deduction
https://www.salliemae.com/student-loans/manage-your-private-student-loan/understand-student-loan-payments/learn-about-interest-and-capitalization/
https://www.investopedia.com/terms/c/compoundinterest.asp
https://mygreatlakes.org/educate/knowledge-center/reduce-what-you-owe.html
