For many people, student loan capitalized interest is an unfamiliar term but is something you need to understand if you are going to be using any of the income driven student loan repayment methods. This term is simply defined as the addition of money added to your loan balance for interest that is unpaid. This occurs when your student loan repayment does not fully cover the interest expense of the loan. It is also called negative amortization.
Under some of the different student loan repayment methods this is becoming more common and many students may not be aware of it. The good thing with the income determined methods is that it helps students stay current and begins the qualifying payment history for possible loan forgiveness. A major disadvantage of these repayment methods is the loan balance maybe increasing. If the borrower changes repayment methods or careers this could add a substantial amount of interest onto their loans.
There are currently four variations of repayment based on a student’s income level where interest capitalization could occur. They are:
- Income Based Repayment
- Income Contingent Repayment
- Income Sensitive Repayment
- Pay As You Earn
Each of these methods have different rules on how unpaid interest is handled under the student loan interest capitalization rules. This will be important to understand since life can have many changes. Not knowing how this interest is added to your loan could cost you thousands of dollars in added payments and interest.
Income Based Repayment and Pay As You Earn have similar rules since both offer some additional assistance with subsidized loans. Income Contingent and Income Sensitive do not offer any assistance with unpaid interest and all unpaid interest will be added to your loan balance. Working with your loan servicer or a financial professional, such as REPAY411 could help you better understand your options.
You must remember an important term in these plans called “Financial Hardship”. In many cases these plans were designed to help borrowers stay current and avoid default. These may not be a good long term solution unless you qualify for an accelerated loan forgiveness program, such as the Public Service Loan Forgiveness Program and others forgiveness plans.
A big mistake many students and parents have made is not properly planning for the financial outcome of the educational loan repayment. Making a short term decision by picking the lowest monthly payment may not be the best long term decision. Proper planning your career path, income growth, personal goals and loan forgiveness options all need to be part of the student loan repayment decision. By understanding the rules student loan interest capitalization can be avoided or minimized.