If you are borrowing a student loan, it is important to have a basic understanding of how interest accumulates, as well as the concept of interest capitalization.
You have heard the saying that nothing in life is free, and your student loans certainly are no exception. However, understanding exactly how your loans cost you money will help you make smart repayment decisions. If your loans are paid strategically, it’s possible to save yourself time and money.
There are three primary factors that contribute to the cost of your loans:
1. Interest
2. Capitalization
3. Length of Repayment
The lender charges you to use their money. This charge is known as interest. Understanding the way interest accrues is essential to managing your debt. The most important fact to know about student loan interest is that if the loan is not subsidized, interest accrues on the outstanding principal balance of the loan—beginning on the date of disbursement. You always have the right to pay the accruing interest— even if no payments are required.
At the end of the year you should receive a tax document (1098-E) from your student loan servicer(s) detailing the exact amount of interest you paid. The good news is that the IRS treats capitalized interest as interest for tax purposes and is deductible as payments of the principal balance are made on the loan. However, no deduction for capitalized interest is allowed in a year in which no loan payments were made.
The initial principal is the total amount you borrowed. Unless the loan is subsidized, interest is likely accumulating on that loan immediately when the loan disburses. At certain points, the unpaid loan interest may be capitalized, which means it will be added to the principal; your accumulated interest will begin to accrue interest. Capitalization usually happens at pre-appointed times, such as when your loan enters repayment. The larger the principal, the higher amount of interest will accrue.
Furthermore, different loans carry different interest rates. The chart on studentaid.gov will help you understand what the interest rates are for your loans.
For loans that are not subsidized, you may choose to pay the interest while you are still enrolled, which can help you to avoid capitalization later and can save you money in the long run.
See how your interest adds up over time, using our interest and capitalization spreadsheet.
The first step is to determine the interest that is accruing on your loan while you are in school. For the example, below we are using a 6.08% interest rate on a $40,500 principal balance. Use the following calculation:
Here are some debt management strategies to help you pay your loans off faster:
Organize your debt by arranging it from highest to lowest interest rate. The highest-rate debt should be your first priority.
Pay as much as possible toward your highest-rate debt. Attempt to reduce the required payment on your lower-rate debt—freeing up monies to go to the higher-cost debt.
Pay with purpose; it can save you money. Don't forget to include your credit card and private loan debts in your strategy— they sometimes can be the most expensive debt.
Send it separately from any required payment.
Send directions telling the servicer which loan the payment should be applied to.
Follow up to make sure your payment was applied accurately.
NOTE: During repayment, all fees and interest must be paid before payments can be directed to the principle of the loan. if you fail to provide detailed directions, your servicer can apply the extra voluntary money to future required payments rather than paying down the interest today.
Capitalization is the process where your loan services adds the accrued and unpaid interest to the principal of your loan. Capitalization causes your principal balance to increase, and then the capitalized interest begins to accrue interest as well. This can be a costly process, so it’s best if it occurs as infrequently as possible.
Capitalization typically occurs whenever unpaid interest accrues on your private or federal student loans. There are two specific instances when this might happen for Direct federal loans:
After a deferment on an unsubsidized loan
If you are repaying your loans under the IBR plan and no longer qualify to make payments based on income
Private lenders each have slightly different rules for how they capitalize interest. Generally for private student loans, capitalization happens at the end of your grace period and after a deferment or forbearance. However, read your promissory note and check with your lender to find out exactly when your private student loan interest could be capitalized.