Student Loan Capitalization / Accrued Interest
"Student Loan Capitalization / Accrued Interest" submitted by SchoolGrantsfor Editorial Team and last updated on Sunday 8th January 2012
When interest accrues on a loan, but isn't paid by the borrower, the accrued interest can be added in to the principal of the loan. This makes the loan balance go up, and you are then accruing interest on a larger balance (essentially, accruing interest on interest). Capitalization is the practice of adding unpaid interest charges to the principal balance of an educational loan, thereby increasing the size of the loan. Interest is then charged on the new balance, including both the unpaid principal and the accrued interest. Capitalizing the interest increases the monthly payment and the amount of money you will eventually have to repay. If you can afford to pay the interest as it accrues, you are better off not capitalizing it. Capitalization is sometimes called compounding. To find out when your unpaid interest will be capitalized, contact your lender or servicer.
With certain loans, such as subsidized Direct and FFEL Stafford Loans, the U.S. Department of Education pays the interest that accrues while the student is enrolled at least half-time, during the grace period, and during periods of deferment. However, for unsubsidized Stafford Loans or PLUS Loans, the borrower is responsible for paying the interest as it accrues during all periods. Interest is also charged to the borrower during periods of forbearance on all loan types (subsidized or unsubsidized). When the interest is not paid, it is capitalized at the end of the grace, deferment, or forbearance period. This increases the outstanding principal amount due on the loan. Interest is then charged on that higher principal balance, increasing the overall cost of the loan to the borrower. To avoid capitalization, look into the option of making interest-only payments on your unsubsidized loan while you’re still in school.
Example of two students:
Jack and Kate. Both have $4,000 in unsubsidized Stafford loans at 6.8 percent interest and have opted for a standard repayment plan. Both attended school for four years and had a six- month grace period on their loans. Jack paid the interest - totaling $1,225 - while he was still in school. Kate made no payments, so the total accrued interest of $1,225 was capitalized at the time repayment began. By avoiding capitalization, Jack saved $645 on the total amount of his repayment—enough money to cover a month’s rent or a car payment and a month of auto insurance.
What’s accrued interest?
Interest accrues on a daily basis on your loans. Factors such as the number of days between your last payment, the interest rate, and the amount of your loan balance determine the amount of interest that accrues each month. Interest does not accrue and repayment does not begin until the student ceases to be enrolled at least half-time.
Let’s say you borrow $10,000 via an unsubsidized Stafford loan and the interest costs on the loan are about $57 a month (that’s at a fixed interest rate of 6.8 percent). You choose to defer paying the interest while you’re in school for four years. The interest that accumulates is known as accrued interest. After four years, about $2,720 in interest will have accrued. When you begin repayment, you’ll owe $12,720—the original $10,000 plus the $2,720 in accrued interest. The interest you’ll repay will be based on this new higher amount. The process of adding interest to the amount borrowed rather than repaying it as it accrues is called “capitalization.”
Accrued interest is calculated on your unpaid principal balance each day. The formula for calculating interest is:
Daily interest = (Annual Interest Rate/365.25 days) X Unpaid Principal Balance
Example: Interest accrual based on a $2,625 loan with an annual interest rate of 9 percent Daily interest = (.068 / 365.25 days) X $3,500 = $.65160848733 per day
You can calculate the monthly interest on your loan by using the Simple Daily Interest Calculation.
For federal subsidized loans, there is no interest accruing while the student is in school and during the grace period. For all other federal and private loans, interest will accrue from when the loan money is disbursed.
Federal Unsubsidized Loans are based on annual and aggregate loan limits and are not need based. Interest on this loan begins to accrue upon the first disbursement. Principal repayment begins six months after graduation or when a student is no longer enrolled at least half time (6 hours for undergraduates, 5 hours for graduates). An unsubsidized loan that is not subsidized by the U.S. Department of Education, will accrue interest from the date of disbursement and will have a higher interest rate than a subsidized loan.