Interest Capitalization

One way student debt gets really big is through interest capitalization. When payments are deferred, interest still accrues on the loan balance. At some point in the future, that interest is “capitalized” or added to the outstanding principal balance. Then the borrower is paying interest on their interest. Yikes.

Any non-subsidized loan accrues interest from the day it’s disbursed. And if your loan is in deferment or forbearance, it’s still accruing interest. However, that interest doesn’t get added to the principal balance until a “capitalizing event” occurs. There are several capitalizing events:

• When the grace period ends– usually 6 months after graduation

• At the end of a forbearance or deferment period

• Loan consolidation

• Change of payment plan

• Default

It’s generally best to pay any amount you can on your student loans while in school and during the grace period, even if it seems like an inconsequential amount. A federal direct loan for a freshman this year would have over $900 in interest accrue over four years of college plus the grace period. Add another loan each year and you can see how quickly loan balances can become large.