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, what is capitalized interest on student loans mean.
In this article, we tackle that question, i.e. what is capitalized interest on student loans. Then I will highlight the most common times that interest is capitalized and two of the biggest misconceptions we hear. At the end, I’ll answer a few more questions about capitalization that we typically receive at FitBUX.
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.
Once you graduate, you’ll owe your original loan balance that you borrowed plus the interest. 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.
Once you graduate, accrued interest is capitalized. This means the lender now considers everything loan balance, i.e. you will owe $5,197.26 and the full amount is now charged interest.
The Most Common Time Interest Is Capitalized
The most common time interest is capitalized is after you student loan grace period is over. This is six months after you graduate and you can do nothing about that.
For example, if you graduate in May, interest will continue to accrue through November. Then in November you interest is capitalized and your first payment will 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.
Unfortunately, there is nothing you can do to stop it. It’s automatically done when you enter repayment regardless if you want it to or not.
Going back to misconception #1, people often times hear capitalized interest is bad and that they should get rid of it. Therefore, they have a misconception that they should try to pay it off before it can capitalize. 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 yes, you can save money by paying off the interest before its capitalized. However, the mistake we see is that many individuals make the payment blindly, i.e. they try to pay off all the accrued interest.
Why is this bad?
You will most likely have multiple loans with different interest rates. They each have accrued interest on them. When interest is capitalized it is assigned to the loan that accrued it and charged that interest rate.
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 pay the full $1,000 of interest before it capitalizes.
You should make your 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.
Thus, when you enter repayment you’d owe $7,800 on the 5% loan and $2,200 on the 1% loan. The mistake people make is that they blindly through the money across all the loans. The weighted average interest rate you’d have (weighted average interest rate is the blended rate amount the two loans) would be 4.12%
If you blindly paid off all the capitalized interest then you’d have $8,000 in loans at 5% and $2,000 in loans at 1%. Your weighted average interest rate would be 4.2%.
Long story short, the faster you lower your weighted average interest weight on your student loans, the more you save…
Other Times Interest Is Capitalized
You have no choice regarding capitalization at the end of your grace period. However, there are other times you do have control of it. These can also be very costly if you make mistakes and don’t consider accrued interest.
- Consolidation: When you merge all your loans together, they are considered a brand new loan. When this happens, any accrued interest on the loans is capitalized.
- When you switch plans: If you switch, let’s say from an income-driven repayment plan to a standard plan, then any of the deferred interest on the loan is capitalized.
- Don’t re-certify on IDR: Each year on IDR, you must recertify your income. If you don’t, you are kicked off the plan. You can always go back on it. However, once you get kicked off, your interest is capitalized but you tax bomb will go up. This is one of the most common mistakes we see people make that are using are IDR Solution to save for the tax.
- End of deferment/forbearance: Sometimes people have emergencies and can’t make payments on your loans. You can enter deferment or forbearance and have your payments suspended. However, your loans still accrue interest. When you exit deferment or forbearance, the interest will be capitalized
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.
Other Interest Rate Resources
2 Myths About Compound Interest
Deferred Student Loan Interest: What You Need to Know
By Joseph Reinke, CFA