There is a lot of advice on student loans. One of the pieces of advice we often times hear is to pay off the interest before it is capitalized.
First off, this is bad advice, there is a better way to do it which I’ll detail in this article.
Second, most are confused as to what capitalized interest on student loans means.
In this article, we tackle this question, highlight the most common times that interest is capitalized, and discuss two of the biggest misconceptions that FitBUX hears related to this subject.
What Does It Mean When Accrued Interest Is Capitalized?
When you are in school, interest is charged everyday on your loans.
However, it is simple interest. In short, what this means is during school you are not charged interest on top of interest. I.e. you are only charged interest on the balance that you owe.
For example, if you borrowed $5,000 at 4% for one year, you’d owe $5,000 in original loan balance and $197.26 interest. The $5,000 is charged interest daily, the $197.26 is not charged at all while you are in school.
Once you graduate, accrued interest is capitalized (or at least it used to be… more on this below). This means the lender now considers everything loan balance, i.e. you will owe $5,197.26 and the full amount is charged interest.
The Most Common Time Interest Was Capitalized
The most common time interest was capitalized is after your student loan grace period is over. This is six months after you graduate.
For example, if you graduate in May, interest will continue to accrue through November. Then in November your interest was capitalized and your first payment would be due in December.
This leads to two major misconceptions that can cost you money.
I often times hear new grads complain about the interest they owe being capitalized. They get frustrated because they are told capitalized interest is bad. Therefore, they want to avoid it from happening.
As of August 2023, you don’t have to worry about. There is a new rule that was implemented that interest will no longer be capitalized on Federal student loans.
For example, if you borrowed $100,000 and accrued $25k in interest as a student, the 25k in interest will not be added to your loan balance. In short, you’ll have a $25k interest free loan.
However, when you make payments, your payment by law has to go towards reducing the accrued interest before it is applied to your balance.
Going back to misconception #1, people often times hear capitalized and/or accrued interest is bad and that they should get rid of it.
Therefore, they have a misconception that they should try to pay it all off ASAP. However, this is a very costly recommendation.
First and foremost, you have to decide if you are doing a pay off strategy or a student loan forgiveness strategy (IDR/Income Driven Repayment Plan).
If you are doing a loan forgiveness strategy then you don’t want to pay anything extra towards your loans. Why reduce the accrued interest when you are trying to get your loans forgiven? It makes no since to do so.
If you decide that you do indeed want to use a pay off strategy then the mistake we see is that many individuals blindly pay off all the accrued interest.
Why blindly paying off accrued interest is bad?
You will most likely have multiple student loans with different interest rates.
They each have accrued interest on them.
For example, you owe $10,000. Let’s say you have one loan of $8,000 with a 5% rate and the other loans is $2,000 at a 1% rate. Total you have $1,000 in accrued interest.
That means $800 of the accrued interest will be assigned to the $8,000 loan, and $200 to the $2,000.
Let’s also assume you are going to make a prepayment or $1,000.
You should make your prepayment payment to one loan.
If you are trying to save the most money in the long run you’d want to target the high interest rate loan.
For example, put the full $1,000 to the $800 of interest and the remaining $200 to reduce how much you owe on the 5% loan.
Therefore, you’d have the following loans remaining:
$7,800 @ 5%
$2,000 @ 1%
$200 of accrued interest at 0%
How Much Does The New Rule Change Save Me
This is different for everyone because it depends on how much you have borrowed and the type of loans you have.
However, I’ll illustrate using the following example.
In the following example, I will assume you borrowed $100,000 at 5% and have $15,000 in accrued interest. In addition, you’ll be paying off your student loans over 10 years.
Capitalized Interest Example
In the old scenario where your student loan interest would capitalize, the total cost over 10 years to pay off your loans would be $146,370.
Since there is no more capitalized interest, you will save money. In this example, the total cost would be reduced to $142,278.
Therefore, in this example, the savings is about $4,000.
What is accrued interest vs capitalized interest?
Accrued interest is not charged interest. Capitalized interest is added to your loan balance and you are charged interest on top of interest. In short, capitalized interest can cost you a lot more money in the long run.
Is it better to pay accrued interest or principal?
Principal. However, you have no choice. It is a Federal law on any loan that you have to first pay any accrued interest before paying off principal on a loan.
In conclusion, understanding the difference between accrued and capitalized interest is vital in managing your student loans effectively.
With the recent changes in the rules, there’s potential to save significantly on your student loan repayment. However, it requires a well-informed strategy, tailored to your specific circumstances.
At FitBUX, we specialize in creating personalized strategies that could save you thousands over the lifetime of your loan.
Become a FitBUX Member and schedule a call with one of our experts to assess your student loan situation and recommend the best course of action. Take control of your financial future today with FitBUX.