Student Loan Interest Capitalization and Recent Policy Proposals: What to Know

Unfortunately, it costs money to borrow money. Your student loan is probably one of the biggest offenders, with your interest being capitalized and added to your loan at various points during its term. 

However, under the COVID-19 federal student loan forbearance, your student loan interest rates can be hard to find. When you log into StudentAid.gov or your servicer’s website, you might see a 0% interest rate listed for each loan. Wouldn’t that be a nice permanent figure?

At Student Loan Planner®, we typically assume our clients have an interest rate of 5% to 7%. If you’re a new borrower or if you graduated during the COVID-19 forbearance, you’ve never experienced the joy of interest accruing on your loans.

What is capitalized interest on your student loan?

When you get a loan, there are two parts:

• Principal. The amount you actually borrowed.
• Interest. The fee you pay for borrowing the money, usually expressed as a percentage of your loan balance.

When you have student loans (or any loan), a portion of your monthly payment goes toward covering the interest charge, and the rest goes toward paying down the principal amount. There are times, however, that you might not be paying the full amount of interest. When this happens, the unpaid interest is capitalized — or added to your principal loan amount.

Because your continued interest rate fees are based on your loan balance, you pay interest on the interest. This can increase your balance over time, especially if you’re on a repayment program that allows you to go long periods of time without paying your full interest cost.

Simple interest on student loans

Unlike other types of debt like credit cards and mortgages, interest on student loans typically accrues on its own. There are some circumstances where your interest may capitalize, or the accrued interest is added to the principal.

This creates an “interest on interest” situation. If a borrower takes out $100,000 in loans and $5,000 has accrued in interest when they graduate, we want to avoid paying interest on both the original principal and the $5,000 interest. There are several circumstances where your interest can be added to your principal.

How do my payments get allocated?

When borrowers exit their grace period after school, they’re automatically enrolled in the Standard 10-Year Repayment plan unless they choose a different plan.

Your payments on the standard plan and other traditional repayment plans seek to satisfy your interest first. This helps prevent interest capitalization in the future.

However, if you sign up for an income-driven repayment (IDR) plan, your monthly payment might not cover your interest charges each month. If this is the case, your interest will be charged, accumulating additional interest year after year.

The goal is to leave that unpaid interest out on its own or to avoid capitalization.

Interest capitalization triggers

According to StudentAid.gov, the following can trigger interest capitalization:

• After a deferment on an unsubsidized loan.
• After a forbearance on any type of loan.
• After the grace period on an unsubsidized loan.
• If you voluntarily leave the Revised Pay as You Earn, Pay as You Earn (PAYE), or Income-Based Repayment (IBR) plans.
• If you fail to annually update your income for some of the income-driven repayment plans.
• If you are repaying your loans under the PAYE or IBR plans and no longer qualify to make payments based on income.

Defaulting on your student loans or consolidating them within the federal system can also trigger capitalization. Also, on the Income Contingent Repayment plan, interest capitalizes annually. Ouch.

Capitalization rules for income-driven repayment plans

If you’re on an income-driven repayment plan, you must understand that the current IDR plans have different capitalization rules.

1. Income Contingent Repayment (ICR). Payment under this repayment plan is typically 20% of your discretionary income and is capitalized annually up to 10% of your original balance. This is currently the only income-driven plan for Parent PLUS Loans.

2. Income Based Repayment (IBR). If you borrowed before 2007, this is likely the plan you’re most familiar with. Payments are capped at 15% of your discretionary income, and interest capitalizes when you no longer have a partial financial hardship.

3. Revised Pay as you Earn (REPAYE). Available to all Direct Loan borrowers, this plan sets payments at 10% of your discretionary income, and interest capitalizes only when borrowers forget to re-certify or voluntarily leave a repayment plan.

4. Pay as you Earn (PAYE). This plan is only available for newer borrowers. Payments are 10% of your discretionary income, but it also has the partial financial hardship requirement. Interest capitalizes when you no longer have a partial financial hardship, but it’s limited to 10% of your original principal balance.

COVID-19 forbearance exceptions

According to the capitalization rules outlined above, you’ll notice interest capitalization occurs after a forbearance on any loan. There’s been zero interest accruing on most loans during the COVID-19 forbearance, but if you had any accrued interest prior to the pandemic, this could be a scary proposition.

The Department of Education has announced that interest won’t capitalize at the end of COVID forbearance. However, if you consolidate your loans for the Public Service Loan Forgiveness or income-driven repayment plan waiver, your interest will capitalize.

If you’re pursuing either of these waivers, capitalization needs to be weighed compared to potential forgiveness.

• If you are pursuing PSLF, student loan capitalization charges are irrelevant. Your balance will be forgiven tax-free.
• If you’re looking into the IDR waiver, it’s best to schedule a consultation with us to review your options.

Will interest capitalization go away?

In July 2022, the Biden Administration announced proposed legislation that hopes to eliminate future interest capitalization on most student loans, starting in 2023.

Let’s say you’ve borrowed $85,000 and currently owe $195,000. In a case like this, this student loan interest capitalization change won’t likely help with past capitalization. It will, however, prevent the explosion of future balances.

If you are using forbearance because you can’t afford payments, this potential interest capitalization policy change could help.

Republican response to student loan reform

In August of 2022, House Republicans announced the Responsible Education Assistance through Loan Reforms Act (REAL Reforms Act). Though it’s unlikely the bill will be passed as written, the REAL Reforms Act also advises ending interest capitalization.

This suggests bipartisan support for ending interest capitalization.

As always, we will keep you updated as we learn more about the future of interest capitalization.

What should borrowers do about capitalized interest in the meantime?

Interest capitalization has been an unfortunate reality for borrowers for decades. However, with all of these changes in motion, there may be hope on the horizon.

Remember, if you are pursuing Public Service Loan Forgiveness, you can be less sensitive to interest capitalization since your balance will be forgiven tax free. Keep in mind capitalization is one of the things we cover in our student loan consultations.

If you are pursuing the IDR waiver, it’s important to review your options before consolidating your loans. If your loans will be forgiven before 2025, you won’t have to worry about paying taxes on your forgiven balance. If your forgiveness date extends beyond 2025, you still have options.

Book a consultation to learn more!

Miranda Marquit contributed to this article.