How Student Loan Capitalization Works
Your student loan accrues interest daily. When you’re in active repayment, part of your monthly payment covers this interest, and the rest reduces your principal—the original amount you borrowed.
However, during periods when payments are paused, like a student loan deferment or forbearance, interest on unsubsidized and private loans continues to build. Historically, at the end of these periods, this accumulated interest would be added to your principal. This is capitalization.
Example: Imagine you have a $30,000 private student loan with a 6% interest rate. You pause payments for one year using forbearance.
- Interest Accrued: $30,000 x 0.06 = $1,800 for the year
- At the end of forbearance, this $1,800 is capitalized.
- New Principal Balance: $30,000 + $1,800 = $31,800
Your 6% interest rate now applies to the new, larger balance, costing you more over time.
Key Update: Capitalization Eliminated for Most Federal Loans
In a significant policy change effective July 1, 2023, the U.S. Department of Education eliminated most instances of interest capitalization on Federal Direct Loans. This means for most federal borrowers, your loan balance will no longer grow from unpaid interest in the following common situations:
- When your grace period ends and you enter repayment.
- After a period of deferment or forbearance ends.
- If you fail to recertify your income on time for an Income-Driven Repayment (IDR) plan.
This change does not apply to everyone. Capitalization can still occur on older Federal Family Education Loan (FFEL) Program loans not held by the government, private student loans, or in specific cases like switching away from certain IDR plans (PAYE, PEPS, ICR) to another plan.
How to Minimize Capitalization’s Impact
While the rules have improved for federal loans, it’s still wise to be proactive, especially if you have private loans.
- Pay Interest as It Accrues: If you have private loans paused, paying the monthly interest prevents it from being added to your principal later.
- Enroll in the SAVE Plan: For federal loans, the SAVE Plan is the most powerful tool. If your monthly payment doesn’t cover all the accrued interest, the government subsidizes (waives) the remainder. This prevents your balance from growing due to unpaid interest.
- Understand Your Loan Terms: If you have private student loans, read your loan agreement carefully to know exactly when capitalization occurs.
Frequently Asked Questions (FAQ)
Q1: Does interest capitalization still happen on federal student loans?
On Federal Direct Loans, most capitalization events were eliminated as of mid-2023. It no longer occurs at the end of grace, deferment, or forbearance periods. However, it can still happen on private loans and some older FFEL loans. Always confirm the rules for your specific loan type.
Q2: Can I deduct capitalized interest on my taxes?
Yes. Once interest capitalizes, it becomes part of your principal. As you make payments, the portion attributable to that capitalized interest is considered tax-deductible under the student loan interest deduction, up to the annual limit. According to IRS Publication 970, this is treated as regular student loan interest.
Q3: How does capitalization affect my credit score?
Capitalization does not directly impact your credit score, as the event itself isn’t reported to credit bureaus. However, by increasing your total loan balance, it can raise your debt-to-income (DTI) ratio, an important factor lenders consider when you apply for new credit.
External Authoritative Source:
For more details on how interest accrues and the new capitalization rules, visit the official Federal Student Aid page on Interest Rates and Fees.