- The total amount you pay on a student loan can increase significantly with capitalized interest.
- Interest capitalized is the unpaid interest added to the loan balance after periods of default.
- You may want to consider paying only interest while you are in school to keep your costs down.
- Read more about Personal Finance Insider student loan coverage here.
Student loans can be a useful option finance your education, the money you pay as interest can fold quickly and make the total value of your loan much higher than the original amount you borrowed. Make sure you understand what you are getting capitalized student loan interest on.
What is capitalized interest?
Interest capitalized is the unpaid interest added to the loan balance after periods of non-payment, including deferral, deferred and after a grace period. This will increase the total loan balance and later you will pay interest on that higher amount, which will increase the total loan value.
Here is an example assuming you are taking out a loan of $ 20,000 at a 5% interest rate. In this scenario, you have a standard 10-year maturity and are not required to make payments during four years of college and a one-year grace period.
In the following table, we compare how much you would pay if you deferred payments for four years of school and a grace period versus paying only interest during that time.
The difference between deferred payments and interest-only payments during this 10-year period is USD 1364… Capitalized interest can quickly become expensive, so try to avoid it whenever possible.
You will also pay less per month after repayment starts if you only paid interest while in school and during the grace period because you are making payments on a lower loan balance. Would you pay USD 265 per month after the deferred payment, while you pay USD 212 per month after paying only interest.
Federal student loan interest
Interest on Direct subsidized loans will be paid by the government while you are in school and during the six-month grace period, so you don’t have to worry about paying interest on your loan during federal leniency.
However, if you start paying off the loan balance before the grace period expires, you will still pay less in interest. Why? Because your initial principal will be lower when you need to start paying interest.
The difference between the 5% interest rate on the $ 10,000 balance sheet and the $ 5,000 balance may seem insignificant, but over a 10-year maturity period, you will pay about $ 1,400 more in interest alone on the $ 10,000 balance.
When Direct unsubsidized loans and Direct loans PLUS are not COVID-19, interest will start to accumulate as soon as your loan funds are paid off, so you can start repaying them before the start of the repayment period.
Private student loan interest
You can request a grace period from your private lender, but unlike federal loans, interest will most likely continue to accrue while your payments are on hold. Private student loans usually provided with higher interest rates than federal student loans.
Private lenders usually offer three or four repayment plans, namely:
- Postponed: You will not make any payments while in school or during the grace period, but interest is calculated and capitalized once payments start. This is the most expensive option overall.
- Fixed: You will pay a set amount each month against the loan. Unpaid interest will be charged and capitalized at the end of the grace period.
- Only interest: As the name suggests, you will be paying interest on a monthly basis.
- Full: You will immediately start paying principal and interest. This is the least costly option because you do not allow interest to be charged and at the same time you are actively paying your balance.
Before you decide to defer your student loan payments until the grace period expires, consider how capitalized interest can significantly increase the cost of your loan.