Interest and Capitalization
If you are borrowing a student loan, it is important to have a basic understanding of how interest accumulates, as well as the concept of interest capitalization.
The initial principal is the total amount you borrowed. Unless the loan is subsidized, interest is likely accumulating on that loan immediately when the loan disburses. At certain points, the unpaid loan interest may be capitalized, which means it will be added to the principal; your accumulated interest will begin to accrue interest. Capitalization usually happens at pre-appointed times, such as when your loan enters repayment. The larger the principal, the higher amount of interest will accrue.
For loans that are not subsidized, you may choose to pay the interest while you are still enrolled, which can help you to avoid capitalization later and can save you money in the long run. Let's look at the difference between paying the interest while in school versus allowing the interest to accumulate.
The first step is to determine the interest that is accruing on your loan while you are in school. Use the following calculation:
Loan principal times interest rate divided by 365 = daily interest rate.
Next, calculate the total interest by the number of days the loan has been collecting interest. In this case you will calculate from the time of disbursement to the time you enter repayment. For this example, we’ll use a student enrolled for 4 years.
Imagine you have borrowed an unsubsidized loan for $10,000 with an interest rate of 5%. Four years later you finish your academic program, use your grace period and enter repayment.
|Interest Capitalizing||Paying Interest|
|Original Loan Amount||$10,000||$10,000|
|Beginning Balance at repayment (interest capitalized)||$12,123||$10,000|
|Monthly Payment (Standard Repayment 120 months)||$129||$106|
|Total Repayment Amount||$15,430||$12,728|
|Total Repayment Interest||$5,430||$2,728|
This helps demonstrate two things: 1) only borrow what you need and 2) pay any interest you can while you are in school. If you avoid over-borrowing and can even a portion of your accruing interest while still enrolled, you can save yourself a significant amount in the long run!