What is Capitalized Interest?
Capitalized interest occurs when unpaid interest charges are permanently added to the main principal balance of your loan. Once interest is capitalized, your lender will start charging you new interest based on that larger, combined amount.
How Capitalization Happens
Capitalization is extremely common with student loans. If you take out unsubsidized student loans, interest begins accruing the day the money is disbursed to your school. However, you are usually not required to make payments while you are actively enrolled in classes.
Because you are not paying the monthly interest, it sits in a separate bucket. Once you graduate and your grace period ends, all the interest that built up over those four years is "capitalized" and added to your principal balance. From that day forward, your interest rate applies to the new, much higher number.
✔ The Cost of Capitalization
Here is a simple mathematical example of how this trap works:
- The Start: You borrow $30,000 at a 6% interest rate. Over four years of college, $7,200 in interest accrues.
- The Capitalization: When you graduate, the $7,200 is capitalized. Your new principal balance is $37,200. Now, your 6% rate is charged on $37,200, making your monthly payments significantly more expensive.
How to Avoid or Stop It
The only way to completely avoid capitalized interest during school is to make monthly interest-only payments while you are enrolled. If you cannot afford that, the next best option is to consolidate or refinance your loans as soon as you have a stable income. Knowing when to refinance your student loans is critical for escaping high rates.
You can run your numbers through our Student Loan Refinance Calculator to see if taking out a new loan at a lower rate will stop the bleeding and save you money long-term.
Frequently Asked Questions (FAQs)
Does interest capitalize during forbearance?
Yes, in most cases. If you place your private student loans or unsubsidized federal loans into forbearance, interest continues to accrue. When the forbearance period ends, that unpaid interest is capitalized into your principal.
Is capitalized interest tax deductible?
Yes. When you eventually make payments that cover the capitalized interest portion of your balance, those specific payments can be deducted on your federal tax return under the Student Loan Interest Deduction, up to the annual limit of $2,500.
