If you read part 1 of this series, you have a basic idea of how to calculate your student loan repayment. The next question you should is, “what happens to the interest you are not paying?” In short, it gets added to your loan. But that is an oversimplification of what happens.
If your Income-Driven repayments are less than the interest, the unpaid interest will accrue. In other words, it will sit there waiting for you to pay it back. Some programs that cap how much interest can accrue. Knowing how your loan and the different IDR plans handle accrual of interest is extremely important.
Certain events will cause the accrued interest to capitalize. Capitalizing your interest adds it to the loan balance. This new, increase balance, is now charged interest. Capitalization can create an increase in the amount of future interest accrual and cause your account balance to snowball.
Avoiding capitalization is a crucial part of any student loan plan, so it is essential to know what would cause your interest to capitalize. Some of the more common, and avoidable, reasons for interest to capitalize are:
- Consolidating your loans
- Changing or exiting an Income-Driven Repayment Plan
- Having a period of forbearance
- Graduating (unsubsidized loans)
How to Avoid Capitalization
Compound interest is one of the most powerful tools for making wealth when it works for you. It can be one of the most devastating hindrances to financial freedom when compound interest works against you. We need to prevent that.
Here are 4 steps tips to avoiding capitalization
If you have financial difficulty and are unable to pay your student loan bills, do not go into forbearance. Immediately apply for, or update your Income-Driven repayment plans.
When updating Income-Driven repayment plans, avoid changing plans unless necessary.
Don’t consolidate your student loans. In many cases, there is no benefit.
Essentially, have a plan. If you create a student loan plan early in your repayment period, you can avoid many of the reasons interest will capitalize.
Your student loan plan should explore no less than the following:
- Will I qualify for any forgiveness options?
- How do I expect my income to grow over time?
- What is my family going to look like?
- Do any of my options require me to consolidate?
A good student loan plan will cover more than this, but this will help prevent your interest from capitalizing.
If you would like to have an illustration of your payment plan options, please contact me, and I will be happy to help.