Most college students are unaware how loan interest or capitalization works, according to a recent study. Opting to delay payments after college or graduate school can determine how much you pay over the lifetime of your student loans.
When the interest on a student loan capitalizes, the accrued interest is added to the principal balance, which is the original amount borrowed. For that reason, the interest charges increase because it is now based on the new higher principal.
Here are 5 examples of when capitalization occurs with federal student loans:
- Not making interest payments during school and during the grace period. For undergraduate and graduate unsubsidized Stafford loans, interest begins to accrue immediately after the loan is dispersed. Subsidized loans are the best option for students, where the federal government pays the interest while the borrower is in school.
- Switching from an income-driven repayment plan. It is important borrowers know that just because they are enrolled in an income-driven repayment, Income-Based Repayment Plan or Pay As You Earn (PAYE), this may not be covering all of the interest accruing on the loan. While some income-driven plans stop capitalizing interest after 10 percent of the original loan balance has been paid, there are consequences from switching out of these plans. For example, unpaid accrued interest will capitalize when a borrower no longer qualifies for a financial hardship, fails to provide proper documentation for the plan’s annual enrollment or exits the plan.
- Forbearance or deferment. A borrower needs to be careful when selecting these options and know the consequences. Interest is still accumulating on student loans even though the loans are in forbearance or deferment. This loan interest can accumulate quickly.
- Consolidation of federal loans. Consolidating multiple loans into one direct loan, means you are creating an entirely new loan. It is important to consolidate right after graduating as a measure to reduce the capitalization interest that comes with federal loan consolidation. Waiting longer to do so typically increases the principal balance.
- Defaulting on a student loan. Interest that was outstanding at the time of default will be capitalized. The principal amount will not only become larger, but the entire balance will be due and payable immediately.
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