Student Loan Interest and Capitalization - What it Is And How It Works | Your Money Worth Blog

Both the U.S. Federal Government and Private lenders, make money on student loan debt by charging borrowers interest on the loaned funds.

The interest rate alone, though, does not take into account accrued interest that can be capitalized on a student loan and increase profits for the lenders at borrowers' expense. And, if you are one of the millions of student loan borrowers, this means extra costs for you.

In this post, I breakdown, what student loan interest is, how it accrues on your student loan, who is responsible for it and when, what happens after accrued interest is capitalized and how to avoid capitalization.

Student Loan Interest

The interest rate on your student loan is the amount charged on the loan, expressed as an annual percentage of the loan principal balance. You can determine the annual interest rate for your student loan from your loan promissory note.

Note: The Student Loan Promissory Note: is a legal document you sign, agreeing to repay your loan, accrued interest, and fees to your lender. Terms and conditions related to whether the interest is variable or fixed, how interest is calculated, when interest is charged, capitalization, repayment requirements and deferment options are also included in this document.

Although your loan annual interest rate tells you the amount of interest that will be charged as a percentage, the rate alone does not tell you how it will be charged. That’s where interest accrual comes in.

Your annual student loan interest rate doesn't tell you how it will accrueClick To Tweet
Interest Accrual - When It Starts

The first thing to know about interest on your student loan is that:

  • It starts to accrue with the first disbursement transaction on your student loan;
  • It accrues up on a daily basis; and,
  • It never stops accruing until the loan is paid off, discharged, forgiven, canceled or otherwise settled.
Interest Accrual - How It's Calculated

Next, you'll need to be aware that the amount of interest that accrues on your loan is determined by the accrual period (in days), the daily interest rate factor, and the outstanding principal balance, as follows:

Interest accrued = daily interest rate factor x accrual period x outstanding principal balance

Where:

Daily interest rate factor = annual interest rate/ 100/ 365 days
Accrual period = number of days over which interest will be calculated
Principal balance = the outstanding loan amount owed

As an example, let’s assume a borrower named Zara has a private student loan with a 10% annual interest rate, a current principal balance of $10,000. She recently put her loan in deferment for a 6-month (180-day) period. The amount of interest that will accrue during that time can be calculated using the formula.

Find:

The amount of interest that accrues during the 180-day deferment period.

Given:

Daily interest rate factor = (10/100) / 365 days = 0.10/365 = 0.000274
Accrual period = 180 days
Principal balance = $10,000

Solution:

Interest accrued = 0.000274/day x $10,000 x 180 days
= $493.15

For your own student loan, you can use this formula to figure out the amount of interest that will accrue, over any period of time.



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Interest Accrual - Who Pays for What & When

Because student loans aren't already complicated enough (*insert sarcasm here*), who is responsible for the interest that accrues depends on the stage of your student life loan cycle  and the type of student loan. The next two figures show who is, typically, responsible for the interest that accrues for these loan types:

  • Private Student Loan
  • Federal Unsubsidized Student Loan
  • Federal Perkins Student Loan
  • Federal Unsubsidized Student Loan
  • Federal Plus Student Loan
  • Federal Consolidation Loan
Who Pays Interest Accrued During the In-School, Grace & Deferment Periods

Who Pays Interest and Capitalization on Student Loans In School, Deferment and Grace Periods


Related Article: The Student Loan Life Cycle; What Is It & How It Works

Who Pays Interest Accrued During the Forbearance & Repayment

Who Pays Interest and Capitalization on Student Loans during Frobearance and Repayment

At every stage of the Student Loan Life Cycle, (In-Shool Period, Post Graduation Grace Period, Deferment Period, Forbearance Period or Repayment Period)  the interest that accrues on your loan is either the responsibility of you and your co-signer(s) or the Federal Government.

From the figures you can see that:

  • The Federal government does not pay the interest on all the different types of student loans it offers.
  • The interest accrued on private student loans (including Caribbean Student Loans) is your (the borrower) and any co-signers', responsibility.
  • When you consolidate your student loans the responsibility for the interest will be determined by the promissory note for the new loan that replaces the older loans.
    • For consolidation done through the Federal government (for Federal student loans only), this may require you to forfeit the grace period and cause your loans to enter repayment, immediately.
    • Note: If you consolidate your student loans (private and/or Federal), with a private lender, the responsibility for the interest accrued will be the responsibility of the borrower(s).

This can be very confusing, I know.

But you need to know this because, as a borrower, even if:

  1. No one explained this to you;
  2. You don't receive a statement or notice on the interest that accrues;
  3. You don't pay attention to notices or statement that detail the interest that builds up on your student loan; or,
  4. Your lender doesn't require you to make payments on your loan interest;

The interest you are responsible for will be included in the balance you owe and what you are expected, and legally required, to repay to your lender.

Note: Check with your student loan promissory note for specific terms and conditions related to accrued interest. The agreement you signed with your student loan lender will determine who is responsible for the accrued interest and under what circumstances.

Another reason this is important to know is because interest accrues and builds up on your student loan, it can be added to your loan principal balance is through the process of capitalization.


Related Article: How I Paid Off $37,000 if Student Loan & Credit Card Debt, & Bought A Home In 5 Years

Capitalization

Capitalization involves the addition of unpaid accrued interest to the principal balance of your student loan. It usually takes place when unpaid accrued interest builds up on your student loan, during the in-school period, or a period of deferment or forbearance. And, even if you might not have been required to make payments during those periods, the interest is still your responsibility.

Capitalization - How it Works

Using the example of Zara’s private student loan, again, let’s assume that at the end of her 180-day deferment period, she never gave much thought to the interest that accrued on her loan and at the end of the deferment period, her lender capitalizes the interest. The capitalization of her loan could be calculated.

Find:

New principal balance after capitalization of interest accrued during deferment.

Given:

Principal balance at start of deferment = $10,000
Interest accrued during deferment = $493.15

Principal balance after capitalization = Principal balance at start of deferment + Interest accrued during deferment

Solution:

Principal balance after capitalization = $10,000 + $493.15 = $10,493.15

After the interest is capitalized on Zara's loan, her new principal balance is almost $500 higher than before the deferment.

Many students are totally unaware (like I was) of the amount of accrued interest building up during these stages of their student loan life cycle, and are surprised when their principal balance at the start of repayment (or after a period of deferment or forbearance) is higher than the original amount borrowed.

Capitalization of the interest accrued is usually the culprit, and from that point forward you will pay a higher amount of interest.

In simple terms, when unpaid accrued interest is capitalized on your student loan, you pay compound interest to your lender, i.e. interest-on-interest.

If you have student loans already, or you are considering relying on some amount for your education, I want you to use this information understand how interest builds up on your loans and avoid capitalization of interest, altogether.

Capitalization means you pay interest on interest to your lenderClick To Tweet
Capitalization - How To Avoid it

Although there is nothing you can do about the fact that that interest accrues on your student loan daily, what you can do is prevent any interest that might build up from capitalizing and increasing the cost of the debt to you.

Start by contacting your student loan servicer or lender to find out:

  • What stage of the student loan life cycle your loan is in.
  • Whether there is an outstanding accrued interest balance on your student loan.
  • If there is currently any outstanding interest, and when it is scheduled to be capitalized.
  • What options are available to pay off any outstanding accrued interest balances before it capitalizes.
  • Whether you are currently accumulating accrued interest on your student loan and how you can start making payments towards interest, even if payments are not required.

I hope you found this breakdown useful!

If so, share this post and let me know your thoughts in the comments.

~ Melisa Boutin