Understanding Capitalized Interest on Student Loans

Q: How is capitalized interest calculated?

Capitalized interest is calculated by determining how much unpaid interest had accrued during a deferment or temporary payment pause. Interest may accrue daily during a temporary payment pause. Lenders may add unpaid interest to your principal loan balance and charge additional interest on the larger principal loan balance. That’s how capitalized interest works.

What Is Capitalized Interest on Student Loans?

Sulaiman Abdur-RahmanUpdated August 3, 2023

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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.

Capitalized interest on student loans is a finance charge that lenders may add to the principal balance of your education loan. Interest capitalization is when unpaid interest accrues over time and gets added to your principal loan balance. Capitalized interest increases your debt repayment burden.A capitalized interest student loan charge increases what you owe toward principal, and then lenders may charge additional interest on the larger principal balance. Most instances of federal student loan interest capitalization have been eliminated under new rules and regulations that went into effect in July 2023.

What Is Capitalized Interest on Student Loans?

As mentioned above, capitalized interest on student loans is a finance charge that lenders may add to the principal balance of your education loan. Federal student loan borrowers may face capitalized interest student loan charges if and when they exit a period of deferment on an unsubsidized loan.Private student loan borrowers may also face interest capitalization in certain cases. Lenders of private student loans, for example, may charge capitalized interest on borrowers who request and receive a temporary payment pause. Private student loan lenders may offer forbearance or deferment options to borrowers facing economic hardship.Although federal and private student loan borrowers may face interest capitalization, most instances of federal student loan interest capitalization have been eliminated under new rules and regulation that went into effect in July 2023.

Is Capitalized Interest Good or Bad?

Lenders and borrowers may have different opinions on whether capitalized interest is good or bad. Capitalized interest is an additional source of revenue for lenders but an additional debt burden for borrowers.What is capitalized interest on student loans? As mentioned above, capitalized interest on student loans is a finance charge that lenders may add to the principal balance of your federal or private education loan. It comprises an accumulation of unpaid interest added to a borrower’s principal balance, which then allows lenders to charge additional interest on the larger balance.“Interest capitalization is a frustrating experience for borrowers,” the U.S. Department of Education said in a fact sheet explaining the new regulations on federal student loan interest capitalization.

How Does Capitalized Interest Work?

Capitalized interest works by accruing during a period when a borrower isn’t making payments on a student loan. Interest capitalization increases what you owe toward principal. The interest is capitalized when a lender adds unpaid interest to the borrower’s principal loan balance and then charges additional interest on the larger balance.A federal student loan borrower who exits a period of deferment on an unsubsidized loan or who overcomes a partial financial hardship on the Income-Based Repayment Plan may face capitalized interest charges. Federal student loan interest capitalization can also occur upon loan consolidation. These are the few instances where federal law requires interest capitalization.What about the other instances of federal student loan interest capitalization not mandated by the Higher Education Act of 1965 as amended? Here are the former instances of federal student loan interest capitalization currently eliminated under the new regulations:

When a federal student loan borrower first enters repayment
When a borrower leaves a forbearance
When a borrower in the Pay As You Earn (PAYE) repayment plan no longer has a partial financial hardship
When a borrower leaves the Revised Pay As You Earn (REPAYE) plan
During periods of negative amortization under the Income Contingent Repayment (ICR) plan or under an Alternative Repayment Plan
When a borrower defaults on a federal student loan

In terms of how student loan interest works, lenders charge a fixed or variable rate of interest on the principal balance of an education loan. The federal government’s Direct Subsidized, Unsubsidized, and PLUS Loans disbursed since July 2006 feature a fixed interest rate.The federal government in March 2020 paused federal student loan payments and imposed a 0% interest rate in response to the Covid-19 national emergency. Many federal student loan borrowers won’t face interest capitalization charges when the payment pause ends.The Covid-19 forbearance is set to end on Aug. 30, 2023. As a result, interest accrual on federal student loans will resume on Sept. 1, and payments will be due starting in October 2023.

Example of Capitalized Interest

An example of interest capitalization is when a federal student loan borrower has capitalized interest added to their principal loan balance after exiting a period of deferment on a Direct Unsubsidized Loan.Federal student loan borrowers in some cases may qualify for an economic hardship deferment lasting up to three years. Borrowers in that case would have their loan repayment obligations paused for three years, and daily simple interest may accrue over that period. When the deferment ends, any interest accrued during the temporary deferment could be “capitalized” or added to the borrower’s principal loan balance. The larger principal loan balance could then be subjected to additional interest charges.Recommended: Calculating Student Loan Interest

Paying Off Capitalized Interest

You can pay off capitalized interest by repaying your student loans. Portions of your student loan payments may go toward principal and interest.Capitalized interest is added to your principal loan balance, so you may have to pay off your student loans in full or receive student loan forgiveness to overcome the capitalized interest conundrum.

Can You Deduct Capitalized Interest on Your Taxes?

Eligible taxpayers who have paid interest on a qualified student loan may claim a student loan interest deduction of up to $2,500 per year on their federal income taxes. Capitalized interest on a student loan is deductible, according to the IRS.Taxpayers with a modified adjusted gross income (MAGI) below $85,000 or $175,000 for joint filers could claim the student loan interest deduction in 2023 if they’ve paid interest on a qualified student loan in 2022.

Avoiding Capitalized Interest on Student Loans

You may avoid interest capitalization on student loans if you avoid deferments and make regular payments on your student loans when due. This may apply if you’re a federal student loan borrower or a private student loan borrower.The U.S. Department of Education eliminated most instances of federal student loan interest capitalization effective July 2023. This may make it easier for you to avoid capitalized interest charges if you’re a federal student loan borrower.Borrowers who want to minimize the impact of student loan interest charges may consider student loan refinancing.There are some potential advantages and disadvantages of student loan refinancing, so consider the following points:

You may refinance a portion of your student loans if you qualify for student loan refinancing
One of the advantages of refinancing student loans is it may lower your student loan interest rate
You can refinance federal student loans and private student loans, but the portion of your federal student debt that you refinance loses its eligibility for certain debt relief programs, including Public Service Loan Forgiveness and Teacher Loan Forgiveness
All student loan refinance companies have their own standards for approving or denying student loan refi applications
It might be difficult to refinance student loans with bad credit
You may request a copy of your credit report to see how much you owe in student loans before refinancing

The Takeaway

Paying capitalized interest and regular interest on your student loans can add up. Possible options for relief may exist if you’re a federal or private student loan borrower.Student loan refinancing may be right for you if you can lock in a lower interest rate. Lantern by SoFi can help you compare student loan refinance rates. Explore your options without impacting your credit score and consider applying with a lender of your choice.**Find and compare student loan refinance options with Lantern.

Frequently Asked Questions

How do I pay off capitalized interest on student loans?

Can you claim capitalized interest on your taxes?

How is capitalized interest calculated?

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About the Author

Sulaiman Abdur-Rahman

Sulaiman Abdur-Rahman writes about personal loans, auto loans, student loans, and other personal finance topics for Lantern. He’s the recipient of more than 10 journalism awards and served as a New Jersey Society of Professional Journalists board member. An alumnus of the Philadelphia-based Temple University, Abdur-Rahman is a strong advocate of the First Amendment and freedom of speech.

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