How does capitalized interest work on student loans?

When you take out student loans, you pay back more than you borrow because of the interest charged on the loan balance. But sometimes, unpaid interest gets added to the balance, which is called interest capitalization. When this happens, you end up paying interest on a higher loan balance, increasing your total repayment costs. 

According to a survey by the Pew Charitable Trusts, around 40% of student loan borrowers owed more than what they had originally borrowed. In order to avoid capitalized interest, learn what can trigger it and how it works. 

What is capitalized interest?

Capitalized interest is unpaid interest on your student loans that gets tacked onto your principal balance. When interest capitalizes, it can increase not only your total loan balance, but your monthly payment, too.

Interest capitalization increases borrowing costs because it means you're paying student loan interest on a higher balance. The good news is that only certain events result in student loan interest capitalization, and they vary based on the type of student loan you have.

Example of capitalized interest on student loans

Let's say you have a $25,000 federal unsubsidized loan with an interest rate of 5.50%, and you're on the standard 10-year repayment plan. You enter deferment for one year. During that time, $1,375 of interest would accumulate.

When the deferment ends, that interest would be added to the $25,000 principal balance, and you'd now owe $26,375. Your monthly payment would jump from $271 to $286. That might not seem like a lot in the short term, but in the long term it adds up. The total amount you'd owe would increase by $1,791.

When does interest capitalize?

When interest gets capitalized on student loans varies by type of student loan, but it only happens during certain periods. 

If you have federal student loans:

Thanks to major student loan reform by the Biden administration, many events that would trigger capitalization for federal student loans have been eliminated due to regulations implemented on July 1, 2023. Some of these events included when borrower’s entered repayment, after periods of forbearance, and when loans entered default. It’s important to note that this doesn’t apply retroactively, but going forward borrowers can benefit from this significant change. 

Interest capitalization still occurs with federal Direct Loans and Federal Family Education Loans (FFEL) managed by the Department of Education in the following instances, set by law:

• After periods of deferment on Direct Unsubsidized Loans and Direct PLUS Loans 
• If you’re no longer eligible for Income-Based Repayment (IBR) or leave the plan 
• When you consolidate with a Direct Consolidation Loan

If you have private student loans:

Since private lenders set their own loan terms, check with your specific lender about when interest can capitalize. In general, interest will continue to accrue on private student loans during all periods of deferment and forbearance. This includes while you’re in school and the six-month grace period after leaving. This accrued interest may capitalize after your grace period ends, and after any requested periods of deferment or forbearance.

How to avoid capitalized interest

You may be able to lower your student loan repayment costs by preventing interest from capitalizing. Here's what you can do:

• Make interest-only payments: Make interest-only payments while your payments are paused - like while you're in college and during your grace period. Paying all interest that accrues during deferment or forbearance means there won't be any interest to capitalize once payments resume.
• Consider a lump-sum payment: You can also make a lump-sum interest payment before the interest on your loan gets capitalized. For example, before your deferment period ends, you could pay off all of the accrued interest.
• Avoid deferment: Since capitalized interest most commonly happens after deferments, the easiest way to avoid it is to look at alternatives. Federal loan borrowers can sign up for an income-driven repayment (IDR) plan, which can reduce monthly payments. In some cases, you may qualify for a $0 payment.

Capitalized interest FAQ

What is capitalized interest vs. accrued interest?

Capitalized interest refers to any unpaid interest being tacked onto your principal balance. This increases your loan principal balance, which means you'll pay more in interest. Accrued interest refers to the interest charges that accumulate between monthly student loan payments.

When does interest start accruing on student loans?

Interest starts accruing immediately on the majority of federal and private student loans. So as soon as the loans are disbursed, interest begins to accrue. An exception to this is federal Direct Subsidized Loans, as the federal government pays the amount of interest that accrues while a borrower is in school and during periods of deferment.

Why am I paying capitalized interest?

Interest is the cost of borrowing, so when unpaid interest accumulates, it gets added to your principal balance. Student loan borrowers are responsible for paying capitalized interest at certain times. For federal unsubsidized student loans managed by the Department of Education, interest capitalizes after a period of deferment or if you leave or are ineligible for the Income-Based Repayment (IBR) Plan. Private loan interest typically capitalizes after a grace period, or after a period of deferment or forbearance.

When does interest capitalize on private student loans?

Interest may capitalize on private student loans after a deferment or forbearance, or when your grace period ends. At this time, any unpaid interest on the loan is added to the total principal balance. Interest capitalization increases the outstanding student loan balance and can result in higher monthly payments.