5 Things Grads Should Know About Student Loans After the Grace Period Ends
Choosing to delay payments after college or grad school or picking a certain repayment plan can determine how much you'll pay over the lifetime of your student loans.
Monique Prince, who graduated from the University of New Hampshire in 2011 with a master's in social work, borrowed nearly $60,000 to pay for her graduate degree. Since graduating, her total loan balance has ballooned by 50 percent to more than $90,000.
"I am on time with my payments, but the payments don't cover the capitalizing interest, which actually becomes part of the principal. It's a disaster. My pay as a social worker will not be enough to eventually pay it all off," says Prince, a clinical social worker from Chester, New Hampshire, who is enrolled in an income-based repayment plan for her federal student loans.
In fact, according to a 2016 Sallie Mae report, " Majoring in Money: How American College Students Manage Their Finances," less than a third of college students were able to answer questions correctly on interest accumulation and its effect on loan repayment.
"There's a complete lack of understanding or awareness of how interest works," says Ellen Roberts, a spokesperson for Sallie Mae, a Delaware-based company that offers private student loans and previously serviced federal education loans.
Roberts says words such as capitalization and accrual are confusing to most borrowers. But she says capitalization is "really nothing more than the additional interest onto the principal loan."
[Read up on 11 terms to know before repaying student loans.]
When interest capitalizes, the accrued interest is added to the principal balance -- the original amount borrowed. For that reason, the interest charges go up because it's now based on the new higher principal.
"The actions that can cause capitalization are most often leaving the grace period six months after graduating, changing your repayment plan and consolidating. It's helpful to minimize the number of times you make any big changes to your loans to avoid capitalization," says Travis Hornsby, founder of Student Loan Planner, a consulting firm that provides student loan repayment advice.
Here are five instances when capitalization occurs with federal student loans.
1. Not making interest payments during school and the grace period: On an unsubsidized Stafford loan for either undergraduates or graduates, the interest begins to accrue after the loan is disbursed. Unlike subsidized loans where the federal government is paying the interest while the borrower is in school, interest accrues after the loan is originated. All that interest capitalizes when a borrower graduates unless interest payments were made during school.
When a borrower chooses to delay repayment with a grace period, interest continues to accrue on the unsubsidized loan.
[Learn to start student loan repayment off right from the first payment.]
2. Switching out of certain income-driven repayment plans: A borrower enrolled in an income-driven repayment plan such as Income-Based Repayment or Pay As You Earn, known as PAYE, may not be covering all the interest accruing with a monthly payment. While that's part of the design of these plans, interest will capitalize when a borrower enrolls in a non-income-driven repayment plan, experts say.
While some income-driven plans stop capitalizing interest after it's more than 10 percent of the original loan balance, there are consequences from switching out of one of these plans. For example, unpaid accrued interest will capitalize when a borrower no longer qualifies for a financial hardship, fails to provide documentation for a plan's annual enrollment or exits the plan.
[Learn about changing student loan payments when you get married.]
"In many cases, interest is still accruing on your loans with these repayment plans unless you're interested in public service loan forgiveness, and that's a different bucket. Income repayment plans can be helpful for the short term, but they're not a long-term solution," says Zack Friedman, founder and CEO of Make Lemonade, a personal finance comparison site.
3. Choosing forbearance or deferment: Interest is still accumulating on loans during forbearance or deferment. The exception is subsidized loans during deferment, when the government pays the interest.
"A borrower has to be careful because that interest can have a snowball effect -- essentially you have interest growing upon interest and that can be an expensive situation," Friedman says.
4. Consolidating federal loans: The federal program allows student loan borrowers to consolidate multiple loans into one direct loan. When a borrower consolidates their old loans, that's creating an entirely new one.
"Think about it like taking all your old principal and accrued interest and putting it into a blender. After the combination you start over with zero accrued interest because everything is now principal with the new loan," says Hornsby from Student Loan Planner.
He usually advises recent grads to consolidate their loan right after graduating as a measure to reduce the capitalized interest that comes with federal loan consolidation, as waiting longer typically increases the principal balance.
5. Defaulting on a student loan: Any interest that was outstanding at the time of default will be capitalized. Not only will the principal become larger, but the entire balance will be due and payable immediately.
"Even if you have filed bankruptcy, generally speaking, your student loan will still be waiting for you on the other side," George Galat, a financial planner from Mosaic Financial Partners, said via email.
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Farran Powell is an education reporter at U.S. News, covering paying for college and graduate school. You can follow her on Twitter or email her at fpowell@usnews.com.