Quick answer
Interest capitalization happens when unpaid interest that accrues while your federal or private student loan is deferred, in forbearance, or in the grace period is added to the principal balance at a defined capitalization event. Once capitalized, you pay interest on a larger balance going forward, which raises monthly payments and total cost over the life of the loan. (See Federal Student Aid: interest and capitalization.)
How capitalization typically works — step by step
- Accrual during deferment or grace.
- For unsubsidized federal loans and most private loans, interest continues to accrue during in-school deferment, grace periods, and many types of deferment or forbearance. (Federal Student Aid)
- For subsidized federal loans, the government pays interest during certain in-school and deferment periods; those loans generally do not accrue borrower-paid interest during those qualifying times. (Federal Student Aid)
- A capitalization event.
- Capitalization usually occurs when the loan leaves deferment and enters active repayment, after certain types of forbearance, when you consolidate loans into a new loan, or at other contract-defined triggers. Your promissory note or loan servicer will define the specific events. (CFPB)
- Interest is added to principal.
- The unpaid accrued interest is added to the outstanding principal balance. This becomes the new principal for future interest calculations.
- Payments and total cost increase.
- Monthly payments are typically recalculated using the higher principal. Because interest is charged on that larger amount, total interest paid over the life of the loan increases — you’re, in effect, paying interest on interest.
Simple calculation example
- Original principal: $30,000
- Interest accrued during deferment: $1,200
- New principal after capitalization: $30,000 + $1,200 = $31,200
If your interest rate is 5%, annual interest before capitalization would be $1,500 (5% of $30,000). After capitalization, first-year interest is $1,560 (5% of $31,200). That extra $60 in year-one interest compounds and raises payments and lifetime cost.
Real-world scenarios where capitalization happens
- End of in-school grace period: Many federal loans capitalize unpaid interest at the end of the grace period when repayment starts. (studentaid.gov)
- After a forbearance: Certain forbearances allow interest to accrue and then capitalize once the forbearance ends.
- Consolidation: If you consolidate student loans into a Direct Consolidation Loan, previously accrued unpaid interest may be capitalized into the new loan balance, depending on the consolidation terms. See our guide to student loan consolidation vs refinancing for differences and trade-offs.
In my experience advising clients, the surprise of a higher-than-expected new balance is the most common cause of missed or late payments in the first 12 months after repayment restarts. I routinely run a capitalization forecast during counseling sessions so borrowers can budget correctly.
Who is most affected?
- Borrowers with unsubsidized federal loans: Interest accrues during deferment and is the borrower’s responsibility.
- Borrowers who take long forbearances: Repeated or prolonged forbearance periods allow interest to compound and then capitalize.
- Private loan borrowers: Most private loans accrue interest during deferment and typically capitalize according to the lender’s terms.
- Graduates who defer payments but do not make interest payments: Small unpaid interest balances over multi-year deferments can become meaningful when combined.
Common capitalization events to watch for
- End of grace period after graduation or leaving school.
- Termination of deferment or forbearance.
- Loan consolidation or refinancing.
- Transfer of servicer or reclassification of a loan (check notices from your servicer).
How capitalization affects repayment plans and forgiveness
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Income-driven repayment (IDR) plans: Capitalized interest increases the principal used to calculate monthly payments and, in some circumstances, the amount forgiven at the end of the repayment term may also increase because forgiveness calculations use the remaining principal and accrued interest. If you’re pursuing Public Service Loan Forgiveness (PSLF) or another forgiven outcome, confirm how capitalized interest is treated with your servicer and reference official guidance. (studentaid.gov)
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Consolidation and forgiveness: Consolidating after capitalization locks in the higher balance under the new consolidation loan; review the pros and cons before consolidating (see our student loan consolidation vs refinancing article).
Strategies to reduce or avoid capitalization
- Pay interest while deferred or in-school: Even small monthly interest payments can prevent capitalization and lower total cost.
- Choose subsidized loans when eligible: Subsidized loans don’t accrue borrower-paid interest during qualifying in-school and deferment periods. (Federal Student Aid)
- Use targeted payments: If you can’t cover full interest, pay at least the accrued interest monthly on unsubsidized loans to prevent growth.
- Avoid unnecessary forbearance: Forbearance may offer short-term relief but can cause capitalization later. Explore alternatives like temporary income-driven repayment adjustments. See our article on how forbearance affects long-term forgiveness and interest accrual for trade-offs.
- Refinance selectively: Refinancing can reduce interest rates if you have strong credit, but note that refinancing federal loans into private loans typically eliminates federal protections and forgiveness options. Compare refinancing pros and cons and timing carefully (see our refinancing guides).
Practical checklist before a capitalization event
- Ask your servicer for a capitalization statement showing how much interest has accrued and the date capitalization will occur.
- Request a repayment estimate using the post-capitalization balance.
- Compare keeping the loan as-is vs making interest-only payments now to reduce the capitalized amount.
- If consolidation is being considered, ask whether accrued interest will capitalize and whether consolidating helps your repayment goal.
Common mistakes and misconceptions
- “Subsidized vs unsubsidized is the same.” Wrong — subsidized loans are treated differently for interest during qualifying deferment periods. (studentaid.gov)
- “Capitalization only happens once.” Capitalization can occur multiple times across multiple deferments, consolidations, or servicing events.
- “I can’t do anything to stop it.” You can make interest payments while deferred or choose repayment alternatives to limit the effect.
Frequently asked questions
Q: Can I avoid capitalization entirely?
A: Not always. Subsidized federal loans may avoid borrower-charged interest during specific periods, but most unsubsidized and private loans will accrue interest that can be capitalized. You can, however, minimize capitalization by making interest payments during deferment or choosing repayment options that limit or delay capitalization. (CFPB)
Q: Does capitalization change my interest rate?
A: No — capitalization changes your principal balance, not the interest rate. But because the principal is larger, your interest dollars each month will increase.
Q: If I refinance after capitalization, can I lower my costs?
A: Possibly. Refinancing to a lower rate can reduce future interest, but refinancing federal loans into private loans eliminates federal protections and potential forgiveness. Review our refinancing pros and cons before deciding.
Example comparisons (illustrative)
| Scenario | Principal before | Accrued interest | New balance | Result |
|---|---|---|---|---|
| Unsubsidized; no payments during school | $25,000 | $1,000 | $26,000 | Higher monthly payment; more lifetime interest |
| Subsidized; government pays interest | $25,000 | $0 | $25,000 | No capitalization from in-school period |
Where to get official information and help
- Federal Student Aid (studentaid.gov) — authoritative details on capitalization, subsidies, and repayment options. (Federal Student Aid)
- Consumer Financial Protection Bureau (consumerfinance.gov) — practical consumer guidance on student loan interest and capitalization. (CFPB)
For targeted help on choices that interact with capitalization, read our pieces on student loan consolidation vs refinancing and how forbearance affects long-term forgiveness and interest accrual. Useful internal reads:
- Student loan consolidation vs refinancing: Pros and Cons — https://finhelp.io/glossary/student-loan-consolidation-vs-refinancing-pros-and-cons/
- How forbearance affects long-term forgiveness and interest accrual — https://finhelp.io/glossary/how-forbearance-affects-long-term-forgiveness-and-interest-accrual-student-loans/
Bottom line
Interest capitalization increases the principal on which future interest is calculated; it can significantly raise monthly payments and lifetime cost if unpaid interest accumulates during deferment or forbearance. The most effective way to limit capitalization is simple: pay accrued interest when you can, choose subsidized loans if eligible, avoid unnecessary forbearances, and weigh the trade-offs of consolidation or refinancing.
Professional disclaimer: This article is educational and general in nature and does not constitute personalized financial, legal, or tax advice. For decisions that affect your unique situation, consult a licensed financial adviser or contact your loan servicer. Authoritative sources used: Federal Student Aid (studentaid.gov), Consumer Financial Protection Bureau (consumerfinance.gov).
