Cold Truth: Interest Capitalization Explained

Before you start reading, please enter your email to follow Slim Fit Wallet. Following helps me to spread awareness about the benefits of living debt free to more people and give you useful content in return. If you are already part of team #slimdowndebt on WordPress, follow on Twitter.

Federal Student Loans

The Student Loan Marketing Association (nicknamed “Sallie Mae”) is the United States’ leading company for financing education. Throughout this blog post, I use the term Sallie Mae to describe all federal student loans regardless of the actualstudent loan servicer.

A borrower will generally pay back more than the original amount borrowed when paying for education using a student loan. This is due to the accrual of interest and interest capitalization. By understanding how interest rates and interest capitalization work, a borrower can be proactive and decrease the amount repaid.

Interest Rates

An interest rate is the amount charged to borrow money. It is calculated as a percentage of the current principal (the amount borrowed). There are two main types of interest rates – fixed and variable rates. Currently federal student loans are only offer fixed interest rates.

  • A fixed interest rate stays the same for the life span of the loan
  • A variable interest rate increases or decreases during the life span of the loan

How Does Interest Grow on Federal Student Loans?

The interest on federal student loans begins to grow (accrue) from the first day the money is sent (disbursed) to the school or the borrower. It continues to grow until the loan is paid in full.

I borrowed $44,000 to attend graduate school. Example 1 shows a breakdown of my graduate student loan accounts by amount and interest rate.

Example 1 – My Graduate Student Loans

Account 1:$8,500.00 borrowed with a 6.550% interest rate

Account 2: $11,000.00 borrowed with a 7.650% interest rate

Account 3:$12,000.00 borrowed with a 6.550% interest rate

Account 4:$12,500.00 borrowed with a 6.550% interest rate



Example 2 – How Interest is Calculated

Example 2 uses account 2 from Example 1 to show how the student loan servicer calculates the annual or daily interest due on the loan.

Account 2 ‒ Annual Interest:  $11,000.00 x 0.0765  =  $841.50 annually

Account 2 ‒ Daily Interest:  ($11,000.00 x 0.0765)  / 365 days  =  $2.31 daily

What is Interest Capitalization?

While the borrower is in school the interest is accruing, but it is not added to the principal. Typically, the borrower’s first payment is due 6 months after school ends. This is known as the grace period. Once grace period ends, the unpaid interest may capitalize. That means the unpaid interest is added to the current principal. Thereafter, the interest rate is calculated based on the higher principal. Example 3 describes interest capitalization in more detail using account 2 from Example 1 and 2.

Example 3: Interest Capitalization

On August 1, 2011, Sallie Mae sends my school $11,000 and the grace period ends on April 27, 2014.  The interest remains unpaid for 1,000 days. Using the daily interest from Example 1, the account accrues $2,310.00 in unpaid interest. The unpaid interest is added to the principal ($11,000.00 + $2,310.00) which amounts to a new principal of $13,310.00.  From that day forward, the interest rate of 7.65% is calculated based on the new principal of $13,310.00.

Account 2 ‒ Daily Interest: (($11,000.00 x 1.0765)  / 365 days  =  $2.31 daily

Unpaid Interest Term: April 27, 2014 – August 8, 2011  =  1,000 days

Unpaid Interest Amount: 1,000 days x $2.31   =  $2,310.00

New Principal with Capitalized Interest: $11,000.00 + $2,310.00  =  13,310.00

New Annual Interest: $13,310.00 x 0.0765  =  $1,018.22 annually

Imagine that happening for each of the four student loan accounts from Example 1.  In my case that is what actually occurred. I accrued thousands of dollars on top of my principal balance because I did not understand how interest and interest capitalization worked. Don’t let the same thing happen to you.

How to Reduce Interest Capitalization?

Try to pay some or all of the unpaid interest before the capitalization period. Calculate what the unpaid interest will be at the time the grace period ends and make a goal to save that amount. If saving for the full amount is difficult, try saving just a portion of the unpaid interest. These actions can help to lower the amount of capitalized interest accrued. In the end, these actions will also help to reduce the total amount due.

By Simone, creator of Slim Fit Wallet

Thanks for reading.