When you borrow a federal student loan, you have to wade through a lot of financial terminology. While navigating all this information can be stressful, knowing how these terms affect your repayment process can help you save money in the long run.
One key term to know is student loan interest capitalization. All federal student loans come with interest. Interest is the cost borrowers pay for a loan. It’s calculated as a fixed percentage of the loan amount, called the principal, and accumulates daily.
Interest capitalization is when unpaid accumulated interest, also called accrued interest, is added to the principal loan balance. This increases the cost of the loan over time because interest is then calculated based on the new, higher loan balance.
What Causes Student Loan Interest Capitalization?
You’re not required to make federal student loan payments while you’re still enrolled in school at least half time, or for six months after you leave school. However, if you have unsubsidized federal student loans, they will still accrue interest during these periods.
When you start repayment, all of this accrued interest will capitalize — meaning it will be added to the principal balance — making your new loan balance higher. Interest can also be capitalized when you miss a student loan payment.
Here’s an example of the cost of capitalization: You borrow $30,000 to pay for college at a 3% interest rate. You complete your program in four years and then have a six-month grace period before you start making payments on your student loan. By then, your loan has accumulated $4,050 in interest.
If you had made monthly payments to cover that interest as it accrued, you would enter repayment with a balance of $30,000. But if you made no payments, the $4,050 in unpaid interest would be added to your principal loan balance, or capitalized, when you enter repayment. This means that going forward, your interest will be calculated based on a new, higher balance of $34,050, rather than on the original principal balance of $30,000.
For a standard 10-year repayment term, this means you would pay an additional $4,693.20 over the life of the loan than if the interest had not been capitalized.
How Capitalization Can Affect Student Loan Repayment
Depending on which repayment plan you’re enrolled in, capitalization may cause your monthly payment amount to increase.
Capitalization can occur when you switch in and out of certain repayment plans. A number of repayment plans are available to federal student loan borrowers. In some plans, your monthly payment is based on the loan balance, with payments calculated to fully cover accruing interest.
But under income-driven repayment plans, for example, which can help make monthly student loan payments lower, your payment is based not on your loan balance but on your family size and a percentage of your income. This means that for some borrowers, an income-driven monthly payment may not be enough to cover all of the interest that accrues between payments. So, if you leave certain income-driven repayment plans, any unpaid accrued interest could be capitalized.
Interest can also be capitalized after a period of deferment or forbearance. For example, if your unsubsidized student loan was in deferment, any interest that accrued during that time is added to the balance at the end of the deferment period. For both unsubsidized and subsidized student loans, any interest that accrued while they were in forbearance is added to the balance when the forbearance period ends.
Currently, because of federal emergency coronavirus relief benefits, the interest rate on most federal student loans is set at 0% through Sept. 30, so interest is temporarily not accruing on those loans.
How to Minimize Student Loan Interest Capitalization
One way to minimize interest capitalization is to make interest-only payments on your student loans while you’re enrolled in school and during your grace period. For unsubsidized student loans, interest accrues from the day you take out the loan.
By paying just interest while still in school, you could minimize the amount of unpaid interest that’s added to the loan balance when you start repayment. This could save you potentially thousands of dollars over the life of your loan, depending on how much you borrowed.
If you’re enrolled in an income-driven repayment plan, you can also avoid interest capitalization by making sure to annually recertify your income information to stay enrolled in your plan from one year to the next.
There are some free online resources that can help you understand how interest capitalization can affect repayment of your federal student loans. Check StudentAid.gov to find out the interest rate on yours and to look up the amount of interest that accrues each month.
You can also check out a loan capitalization calculator, such as the one on the NHHEAF Network website, to see how much money even small interest-only payments could save you over time.
More from U.S. News
Student Loan Interest Capitalization: What to Know originally appeared on usnews.com