Updated: Jul 12, 2023
Article highlights
- Student loan interest accrues daily while you are still in school and during your grace period—well before your first payment is due.
- Any unpaid interest that accrued is added to the principal balance when your loan enters repayment. This is called capitalization. Going forward, interest accrues on this new, higher amount.
- There are ways to avoid or reduce capitalized interest such as making interest-only payments while in deferment or during the grace period.
When you take out a student loan to pay for college, interest charges come with the territory. Consider them the price you pay for borrowing money. You can defer making payments toward the principal balance and interest while you’re in school and during your grace period, but do you know what interest is doing during this time and how it impacts your student loan?
Here's a closer look at how interest and capitalized interest work—and how you can avoid extra costs.
What is capitalized interest?
Let’s first clarify how student loan interest works. Interest on a student loan accrues daily, starting the day your money is disbursed to the school. For most student loans, you are responsible for paying back the interest that accrues while you're in school and during your grace period. The grace period is a window of time when the student is not required to make student loan payments, which is usually six months after graduation for undergraduate loans or dropping below half-time enrollment.
When it’s time to start repaying your student loan, any unpaid interest that accrued is added to your principal balance, which is called capitalization. (The principal balance is the original amount of money you borrowed.) Once in repayment, interest will be calculated using the new, larger principal balance. This increases the total amount you’ll pay for your student loan because you are essentially paying interest on interest.
How is capitalized interest calculated?
Here’s how capitalized interest adds up. Let’s say you take out an undergraduate student loan starting your freshman year in college. You borrow $10,000 and have a fixed interest rate of 6%. You decide not to make payments until six months after you graduate. Here’s how much interest will accrue while you’re in school and during the six-month grace period:
Zero payments Payments begin when grace period ends |
|
|---|---|
| Original principal balance | $10,000 |
| Fixed interest rate | 6% |
| Estimated monthly interest accrual | $50.00 |
| Total accrued interest while in school (45 months) | $2,250 |
| Total accrued interest during grace period (6 months) | $300 |
| Total unpaid interest | $2,550 |
| New principal balance | $12,550 |
In this example, you would accrue $2,550 in interest, which would then be added to your principal balance. For more examples and to see how capitalized interest impacts the total cost of your loan, check out this article: Is making student loan payments while in school worth it?
When does interest capitalize?
Interest capitalizes following periods of grace, deferment, and forbearance. Also, interest accrues during certain types of repayment programs where monthly payments may be temporarily postponed, and it capitalizes when it’s time to start making payments.
What type of student loans accrue and capitalize interest?
It's important to understand the type of student loan you have so you know if you (or the federal government) are responsible for paying the accruing interest and when it capitalizes. Since all loans accrue interest, this will help you determine what steps you can take to avoid or reduce the amount of capitalized interest on your loan. Here’s a helpful guide:
| Subsidized Federal Student Loans | Unsubsidized Federal Student Loans | Private Student Loans | |
|---|---|---|---|
| Am I responsible for accrued interest while I’m in school? | No | Yes | Yes |
| Am I responsible for accrued interest during the grace period? |
No | Yes | Yes |
| Am I responsible for accrued interest during deferment? | No | Yes | Yes |
| Am I responsible for accrued interest during forbearance? | Yes | Yes |
Yes |
| Does unpaid accrued interest capitalize? | Yes | Yes |
Yes |
Both federal and private loans have options to help you during times of financial need. Interest accrues and capitalizes for some of these options so check with your lender or loan servicer to learn more about how interest works. Also keep in mind that every private student loan is different so make sure you understand the details on how capitalized interest works for your loan.
How can I avoid capitalized interest?
Capitalized interest might be an unwelcome surprise if you aren’t expecting it. Here are some ways to avoid or minimize its impact on your student loan:
- The best way to avoid the effects of capitalized interest is to pay the interest while you’re in school and during your grace period. The best time to start is when your loan disburses.
- Cash-strapped college students may find it difficult to make interest-only payments while in school. Making small payments can reduce the amount of interest that capitalizes if full interest payments are not feasible.
- Another option is to make payments during the summers and grace period when you can focus more of your time on working rather than studying.
- Try to stay on top of your payments. Contact your lender or servicer before you miss a payment to see what options they have to help. Keep in mind that if you enroll in programs that stop or reduce your payments, interest will continue to accrue and will be capitalized once you resume regular payments.
