What is Capitalized Interest on Student Loans?

Most student loans will let you wait to start repayment until you leave school, with many even adding an extra six-month grace period after graduation. This sounds like a good deal — but sometimes it can cost you, due to a thing called “capitalized interest.”

Most of these loans are still charging you interest, even though you’re not paying. You might think the lender just adds an extra charge to your first few bills to cover this, but with capitalized interest on student loans, that unpaid interest instead gets added to the original loan amount itself.

In other words, you will be paying interest on that unpaid interest, costing you significantly more money.

Fortunately, the government has recently gotten rid of capitalized interest on federal loans in most cases — instead, you’ll just pay what you owe in interest and nothing more. However, you still might encounter this unexpected cost, especially with private student loans. Here’s what you should know about capitalized interest on student loans.

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When does capitalized interest apply to student loans?

Although new borrowers will see fewer instances of interest capitalization on student loans, it’s still important to know when (and how) it may apply to you. The main differences are between federal and private student loans.

Federal student loans

Prior to July 1, 2023, interest capitalization applied to many federal student loan borrowers entering repayment, depending on the type of student loan they had.

Direct Subsidized Loans were never a problem, because the government covers all the interest until you start repayment (following your grace period) — there’s nothing to “capitalize.”

In contrast, Direct Unsubsidized Loans, along with PLUS loans and loans from the former Federal Family Education Loan (FFEL) program, could rack up unpaid interest. Previously this was added to your loan’s principal, so you would end up paying interest on the interest.

Since July 1, 2023, however, new borrowers entering repayment for the first time will just need to pay down the actual amount of unpaid interest — and nothing more. This also now applies to unpaid interest from student loan forbearance or from most income-driven repayment plans.

Still, there are some cases where you could find capitalized interest on federal student loans, as shown below.

It’s also important to note that this change in capitalized interest is not being applied retroactively. In other words, if you had unpaid interest capitalized in the past, you’re still on the hook for it and must pay back the full balance of your loans.

Private student loans

Unlike federal student loans, private student loans are considered a business venture. That means that, while regulations exist, lenders can make up many of their own guidelines, loan terms and requirements.

If you have a private student loan, you may or may not have to make payments while you’re in school — that depends on your lender. But if you don’t (and if you have a post-graduation grace period to boot), your interest will more than likely accrue and capitalize when you begin to repay your loan.

Likewise, deferment and forbearance aren’t always offered on private student loans, but when they are, your loan will often accumulate interest that, if unpaid, capitalizes at the end of these periods.

How much does capitalized interest cost?

The cost of capitalized interest will vary depending on your loan amount and terms. A large loan balance, high interest rate and long period of deferment can all increase your capitalized interest costs.

Consider the following example: You took out a $40,000 private student loan at a 5% interest rate on a 10-year repayment term. If you don’t pay any interest during four years of college, your loan will accrue about $8,667 in interest.

Assuming the interest is capitalized when repayment starts, your new balance will be $48,667 when you graduate. What does this mean for the total cost of the loan? You’ll end up paying $61,942, thanks to interest capitalization, versus just $59,578 if you had paid the interest while you were in school —a difference of $2,364.

Or to put it another way, your monthly payment would likely be $516 — $92 higher than the $424 you would be paying without the capitalized interest.

Can you avoid capitalized interest on student loans?

Federal student loans

Two of the easiest ways you can avoid capitalized interest are taking out federal student loans versus private and avoiding deferment if you have a Direct Unsubsidized Loan.

You can also avoid capitalized interest by remaining on the income-based repayment plan (IBR) (if applicable), but this could be difficult since your eligibility will ultimately depend on your income.

Monthly payments on the IBR are 10% or 15% of your discretionary income. To be eligible for IBR, your monthly student loan payment must be lower on the IBR plan than it would be on the standard repayment plan. So if your income exceeds a certain limit, you’ll need to choose a new repayment option.

Being forced off the IBR isn’t necessarily bad news — after all, it means you’re making more money. It also means, however, that the interest that accrued while you were on the IBR will now capitalize.

Private student loans

Private student loans don’t come with the same borrower protections that federal student loans do, but there are still ways that you can avoid interest capitalization, including:

Paying accrued interest in full: Your accrued interest can’t capitalize if you pay it in full after leaving school, after your additional grace period (if any) or when you exit deferment or forbearance. However, this can be difficult to do, depending on your income and the amount of interest you need to pay off.

Making interest-only payments: If you’re not required to make payments while in school, during your grace period or any other reason (such as forbearance), you could still make small payments to cover the interest. To do this, you may need to track down your student loan servicer and keep track of how much interest is accruing on your loan.

Can you deduct capitalized student loan interest?

While capitalized student loan interest can increase your costs of borrowing, there is one silver lining: You can deduct capitalized student loan interest on your income taxes.

The student loan interest deduction lets you deduct up to $2,500 of the student loan interest you paid in the last year from your taxable income.

Unlike a tax credit, you won’t get this money back — rather, the deduction reduces your amount of taxable income.

As long as you paid student loan interest in the past year (whether capitalized or not), you can claim this deduction on your tax return.

Why does capitalized student loan interest matter?

Thanks to recent student loan reform, effective July 1, 2023, most federal student loan borrowers shouldn’t have to bear the brunt of capitalized interest.

When it comes to private student loans, though, capitalized interest can become a huge financial burden if left unchecked. The more frequently that interest is added to the current principal, the more interest you will pay.

If you know you won’t be making student loan payments for a period of time — whether it’s because you’re in school or you’ve been granted deferment — be aware of whether interest is piling up and have a plan for how to deal with it.

Another strategy for lowering your interest costs is refinancing your student loans for a better rate. If you can qualify for a lower interest rate, you could lower your overall costs of borrowing. However, this only typically applies to private student loans.

We generally don’t recommend refinancing federal student loans. If you do, you’ll lose borrower protections like income-driven repayment plans and loan forgiveness. Instead, a Direct Consolidation Loan is often the better choice, unless you’re near the end of your repayment.

In any case, it’s important to understand interest capitalization and what it can do to your loans — that way, you’ll know how to handle it when it’s your time to repay.