Student Loan Interest Capitalization
Capitalization is the addition of interest to your principal balance. When interest is added to your principal balance, you are charged interest on that interest (compounding interest), thereby increasing your total loan costs.
There are specific events that trigger the capitalization of student loan interest:
Your goal is to minimize the number of times capitalization occurs during student loan repayment
Changing Loan Status
You can confirm the loan status for each student loan when you are logged into your account at NSLDS.ED.GOV. Generally, when you are enrolled in school at least half-time, your loan status will be “in-school” or “deferred.”
When you finish school or are no longer enrolled at least half-time, and you have exhausted your six month grace period, your loans will automatically change to “repayment” status. At this point, any unpaid interest you have from school will capitalize to create your starting loan repayment balance. This capitalization event is unavoidable.
Starting Repayment Balance = Amounts borrowed + Accumulated interest during school and grace period
Deferment or forbearance are sometimes used to postpone your scheduled loan repayment while enrolled in advanced education (internship, residency, masters or PhD programs), or during periods of economic hardship. During periods of deferment and forbearance, you continue to accrue interest on your unsubsidized and plus loans. When you exit deferment or forbearance, any unpaid interest that is not paid will be capitalized. Periods of academic deferment or forbearance do not count towards repayment periods.
The income-driven repayment plans have made deferment and forbearance obsolete for veterinarians. You will save yourself significant cost and repayment time utilizing IDR over a deferment or forbearance. When you defer your loans, not only does interest accumulate that will be capitalized when you exit deferment and enter repayment, but you also extend the time that you have to deal with your loans.
Let’s say you borrow $185,000 for school and graduate in 2017. When you graduate and enter repayment after your grace period, you may have an additional $25,000 of in-school interest capitalized, bringing your starting repayment balance to $210,000 with an interest rate of about 6%. Under an IDR, your starting repayment balance could remain constant at that level.
Alternatively, if you defer your loans during an internship, you will accumulate interest on your $210,000 starting repayment balance at 6%. That is about $12,600 of additional interest. If you start repayment after your internship, your new starting repayment balance will be $222,600 for the duration of repayment. If you do a second internship or residency, you can add an additional year of interest for each year you defer, increasing the amount of compound interest that accrues during repayment.
Colleagues don’t let other colleagues defer their loans. Utilize an income-driven repayment plan!
A federal consolidation loan can be useful for making older loans qualify for some of the newer repayment plans, like Pay As You Earn (PAYE) and Revised Pay As You Earn (REPAYE). However, a consolidation loan will actually replace the loans that are consolidated, effectively issuing you a new loan in its place. That means any unpaid interest that has accumulated on those older loans will be capitalized and added to the new consolidation loan balance.
CAUTION: In addition to capitalizing unpaid interest, a consolidation loan also erases the repayment history for the loans it replaces. If you have been making qualifying income-driven or PSLF payments, those will be lost when the new consolidation loan is issued.
Failing the PFH Test Under Certain IDR Plans
When you submit your annual income documentation for Income-Based Repayment (IBR) or PAYE, there is a PFH test to see if your current minimum monthly payment under IBR or PAYE is less than your standard 10-year repayment amount when you first entered repayment. If you pass the test, then your payment amount will be calculated based on our income and no capitalization will occur.
However, if you no longer demonstrate a PFH, then your minimum monthly payment will be equal to the standard 10-year repayment amount when you entered repayment and unpaid interest will be capitalized.
Under IBR, all of your unpaid interest is capitalized when you no longer demonstrate a PFH. Under PAYE, only an amount equal to 10% of your starting repayment balance will be capitalized. Any remaining interest will remain as unpaid interest in your loan account.
REPAYE does not have a PFH test. As long as you continue to provide annual income documentation, no unpaid interest will capitalize under REPAYE and your minimum monthly payment will always be 10% of your discretionary income.
Failing to Provide Annual Documentation for an IDR Plan
In order to continue having your minimum monthly payment based on your income, you must provide timely annual income documentation. If your loan servicer does not receive the adequate documentation in time:
• Under IBR, all of your unpaid interest will capitalize and your repayment amount will be the standard 10-year amount when you entered repayment.
• Under PAYE, only an amount equal to 10% of your starting repayment balance will be capitalized. Any remaining interest will remain as unpaid interest in your loan account and your repayment amount will be the standard 10-year amount when you entered repayment.
• Under REPAYE, all of your unpaid interest will be capitalized and you will be placed in an alternate repayment plan that is calculated to ensure your loan is paid in full based on the number of years you have remaining in REPAYE.
In order to get back into compliance for your IDR, you need to provide adequate income documentation. At that point, you can again have your minimum monthly payment calculated based on your income and receive credit for the time you paid a standard 10 year or alternate plan amount towards the maximum repayment periods and forgiveness. The only exception is that payments made under the alternate program in REPAYE will not count towards PSLF if you are working for a qualifying employer.
The easiest way to avoid any of this messiness is to set a calendar reminder each year and provide timely income documentation to your loan servicer, either directly or via studentloans.gov.