Interest Capitalization

Capitalization refers to the addition of unpaid interest to the principal of a loan. After interest is capitalized, it also begins generating interest, so the total amount of interest you pay increases.

There are several circumstances in which unpaid interest is capitalized:

1. When you finish school and enter repayment.
2. When you perform a Direct Loan Consolidation.
3. At the conclusion of grace, forbearance, and deferment periods.
4. If you voluntarily leave or change IDR plans.
5. If you fail to re-certify your income for an IDR plan.

Sometimes interest capitalization is unavoidable (e.g., finishing school) or a consequence of a wise financial decision (e.g., switching IDR plans to lower your payment). However, you should avoid situations in which your unpaid interest is capitalized, if possible.

It's helpful to look at an example to understand how interest capitalization works.

Dr. Smith has been enrolled in PAYE for 3 years. Her loan has a principal balance of $300,000 and she has $20,000 of unpaid interest. Her interest rate is 5% annually.

She only has to pay interest on her principal, so her annual interest charge is 5% X $300,000 = $15,000.

Unfortunately, she forgets to recertify her income on time, so her unpaid interest is capitalized. She now has a principal balance of $320,000. Her interest charge will now increase to $16,000 annually (5% X $320,000).