Student loans are already super expensive. You wouldn’t ever wish, even in your dreams for it to be more than it already is. Unfortunately, that is exactly what capitalized interest will do to your student loans. Your debt may increase even before you get wind of what has transpired and try to get a handle on it.
Table of contents
- Capitalized Interest
- Cost to you
- Accrued and Capitalized interest
- Causes for capitalized interest
- Avoid getting into Capitalized interest
- Tax deduction
What does Capitalized Interest mean?
If you do not pay the interest on your loan as it accrues, then it gets added to your loan balance and this process is known as interest capitalization which can end up increasing your loan amount significantly. It does not end there, beyond this, your lender will now start charging interest on your interest that has been capitalized, further increasing your student loan debt.
Capitalized interest not only increases your debt, but it also means that eventually you will have to pay even more interest as your principal and accrued interest have now combined into one, leaving you to pay even more interest on your unpaid interest.
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How much can it cost you?
Let’s imagine that you borrowed $5,000 each year that you’re in school, having an interest rate of 5% per year. After 4 years of school and a 6 month grace period, the interest accrued is now $2,937. This interest will capitalize during repayment, getting added on top of your existing balance. This leads to you owing $22,937. Not just that, you will also pay interest on top of that capitalized interest.
Now, this can be avoided by paying off the interest before capitalization. If you pay the $2,937 owed in interest before it can be added to your balance, you would owe $20,000, which means you could save $802 over the life of this loan.
From this example, you can easily imagine how capitalized interest can rapidly increase your student loan debt.
Difference between Accrued Interest and Capitalized Interest
Accrued interest is the interest that has been accumulating since your last payment, but which has not yet been capitalized or added onto the principal balance of your loan.
Let’s take another example, If you owe $10,000 on an interest rate of 5%, then the daily accruing interest will turn out to be ($10,000 x 5%) / 356 days, which equates to $1.37 / day.
If your last payment was 20 days ago, the accrued interest now becomes $1.37 x 20 which comes up to $27.40. Now, imagine you failed to make a payment on the loan during your latest payment date or your latest payment does not cover the interest. This would now result in the interest being added to your principal balance and this is called capitalized interest.
Causes for accumulating Capitalized Interest
For Federal Loans:
After Forbearance duration
End of the unsubsidized loan grace period
End of the unsubsidized loan deferment period
Failure to recertify income annually for the REPAYE, PAYE and IBR plans
Being on an Income-Contingent Repayment (ICR) plan
Lost qualification to make payments based on your income under PAYE or IBR
After Federal Loan Consolidation
Grace Period Duration ended
Deferment Duration ended
Forbearance Duration ended
Ways to avoid getting Capitalized Interest on your loan
Repay your interests before they capitalize
Try not to change your IDR plans too often
Be sure to recertify your IDR eligibility each year
Give refinancing a thought
Be sure to make minimum interest payments at the least
Consider enrolling in a repayment plan that best suits your needs
Start paying off your unsubsidized loans while still in school
Set up automatic payments to save yourself some trouble and stress
Is it Tax deductible?
YES, capitalized interest is indeed tax-deductible for the year in which it has been paid.
Tax deductions can only be claimed on the interest after it has been paid, not before.
Having programs that compound the interest on your student loans is very dangerous.
Capitalized interest is one such method that lenders can use to significantly inflate your student loan debt, making it harder to pay off your loans and giving you headaches for a much longer period of time. Understanding how capitalized interest works and taking steps to avoid it from happening to you will keep your debt from ballooning out of control.