There are basically two reasons why your student loan might cost more than what you originally borrowed. These are; interest payment or capitalized interest payment on your student loan. So I will fully explain what Capitalized student loan interest is and ways to avoiding it.
Compound interest is one of an investor’s most cherished tools. Interest being added to your principal allows your money to grow at an increasing rate each year. There are times when interest is added to your student loan principal. It’s called capitalized student loan interest
What is Capitalized Student Loan Interest?
Capitalized interest is unpaid interest that has been added to your student loan, thereby increasing your total repay. Most loans, including student loans, are made up of two parts — principal and interest. When loans are paid back on a normal schedule, you pay the appropriate amount toward the principal and interest each month.
However, if you’re paying less than what you would on a normal schedule, you’ll accumulate unpaid interest. This unpaid interest is a problem because there are times when it can capitalize.
When this happens, the capitalized interest is added as principal to your loan. After this occurs, your interest charges are based on this new loan balance moving forward. And for the rest of your loan repayment schedule, you’ll literally be paying interest on your interest.
How Much Does Capitalized Interest Cost?
Say you borrow $5,000 each year you’re in school at an interest rate of 5% each year. Over four years of school and a six-month grace period, $2,937 in interest accrues. At repayment, that interest amount will capitalize — get added to your balance — and you’ll owe $22,937.
Going forward, you’ll pay interest on top of that capitalized interest — an extra $31 a month, in this case.
But you can avoid this by paying off the interest before it capitalizes. If you pay the $2,937 in interest before it’s added to your balance, you would owe $20,000. By avoiding capitalization, you would save $802 over the life of the loan, making it easier to pay off your student loans sooner.
What Causes Interest to Capitalize on Student Loans?
There are several situations in which interest capitalizes.
For federal student loans, capitalization of unpaid interest occurs:
When the grace period ends on an unsubsidized loan.
After a period of forbearance.
After a period of deferment, for unsubsidized loans.
If you leave the Revised Pay as You Earn (REPAYE), Pay as You Earn (PAYE) or Income-Based-Repayment (IBR) plan.
If you don’t recertify your income annually for the REPAYE, PAYE and IBR plans.
When you no longer qualify to make payments based on your income under PAYE or IBR.
If you’re on the Income-Contingent Repayment (ICR) plan, it capitalizes annually.
When you consolidate federal loans.
For private student loans, interest capitalization typically happens in the situations below, but check with your lender to confirm.
Money can be really tight while you’re in school. If you were rolling in dough, you wouldn’t be needing to take out student loans in the first place, right?
However, if you bring in any income whatsoever during your college years, it could be a smart move to pay off the interest on your loans as they accrue. Some private lenders, like CommonBond, even offer interest-only repayment plans to students until they graduate.
Whether you choose to pay off your interest as it accrues or in one lump sum doesn’t matter. The key is that you must pay it off before repayment begins.
2. Don’t Change IDR Plans Too Often
There are situations when changing IDR plans could be a smart move. But keep in mind that the interest you’ve accrued on one plan capitalizes when you switch to another.
Also keep an eye on your student loan servicer. Some have been known to incompetently switch customers from one plan to another when they shouldn’t have.
Has your student loan servicer switched you to a different IDR plan without your consent? If so, you can challenge this. Ask your servicer to fix its mistake and request that the capitalized student loan interest be removed from your loan balance.
3. Recertify Your IDR Eligibility Each Year
This one seems simple, but it’s so important. Don’t allow the recertification period to slip by without sending in your proper income verification.
Simply forgetting to recertify could not only make your payments skyrocket but can cause your unpaid interest to capitalize as well.
Set a reminder on your phone. Do whatever you need to do to make sure that you don’t forget to get this done each year — and well before the deadline. It could save you a ton of money.
4. Consider Refinancing Your Student Loans
While refinancing may not be able to keep your student loan interest from capitalizing, moving to a loan with a lower interest rate could still save you money overall.
Keep in mind that if you refinance from a federal loan to a private loan, you’ll lose all federal benefits, like access to IDR plans and the possibility of PSLF.
How can a graduate student reduce capitalization on student loans?
Choosing to request a student loan deferment, you won’t have to make principal and interest payments during your deferment period. Your interest will continue to accrue (grow) while your loans are deferred, and at the end of the deferment, any Unpaid Interest will capitalize (be added to your loan’s Current Principal).
Is student loan interest tax deductible?
Your student loan interest both federal and private may be eligible for a tax deduction.
How interest accrues on student loans
The interest on your student loan begins to accrue (grow) on the first day we disburse (send) your loan’s funds to you or your school. It continues to accrue until you’ve paid off your loan. The interest rate for your loan is listed in your disclosure documents and billing statement.
Why would student loans accumulate unpaid interest? Unpaid interest can accrue anytime you’re paying less interest on your student loans. Then you would by following the Standard Repayment Plan.
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