If interest on a student loan is not paid as it accrues, the interest is added to the loan balance. This process is called interest capitalization. Interest capitalization can increase the size of a loan significantly. After the interest is added to the loan balance, the lender will start charging interest on interest, causing the loan balance to grow even faster.
Interest capitalization most often occurs during temporary suspensions of the obligation to repay a student loan, called deferments and forbearances. During a deferment, the federal government pays the interest on subsidized loans, but the interest on unsubsidized loans remains the responsibility of the borrower. During a forbearance, the interest on both subsidized and unsubsidized loans remains the responsibility of the borrower. Examples of deferments include the in-school deferment and economic hardship deferment. Interest can also be capitalized in repayment plans that are negatively amortized, such as income-based repayment (IBR) and pay-as-you-earn repayment (PAYE), where the monthly payment may be less than the new interest that accrues.
Typically, if an undergraduate student or the parent of an undergraduate student defers repaying federal student loans while the student is in school, this may increase the loan balance by 10% to 20% of the original principal balance.
Federal student loans made in the Direct Loan program capitalize the interest only once, at the end of the deferment or forbearance period. Federal student loans in the Federal Family Education Loan (FFEL) program and private student loans may capitalize the interest monthly, quarterly, annually, or at repayment.
Accordingly, if a student is considering whether to pay the interest on a Direct Unsubsidized Loan as it accrues during an in-school deferment, it may be better to use the money to borrow less. Interest isn’t charged on the unpaid interest on an unsubsidized federal loan until the unpaid interest is capitalized when the borrower enters repayment. In contrast, interest on new unsubsidized federal student loans begins accruing upon disbursement. So it may be better to use extra money to borrow less, as opposed to paying the interest as it accrues, at least on federal student loans, because it will lead to less interest accumulating. On the other hand, unpaid interest on private student loans may be capitalized more frequently, so it may be better to pay the interest on a private student loan as it accrues.
While deferring repayment can provide a borrower with some financial relief, it is not a long-term solution to financial difficulties. Interest capitalization adds the interest to the loan balance, digging the borrower into a deeper hole. If the borrower’s financial situation has not improved, the borrower may be less capable of repaying his or her student loans after the forbearance or deferment than before. An extended period of nonpayment can cause the loan balance to grow much, much bigger.