For many borrowers, this letter looks and sounds like a bill, even though it says it isn’t a bill. The unpaid interest notice letter often creates more questions than what it answers. Should I make a payment? What is interest capitalization? Is this bad? What happens if I don’t pay it off and let it capitalize?

Even though the unpaid interest capitalization letter might seem like a problem, for most borrowers, it is a non-event.

What does a Notice of Unpaid Interest letter mean?

Borrowers on a deferment or forbearance are not required to make student loan payments. Current students and those who just graduated fall into this group. Even though payments are not required, interest still accrues.

The good news for borrowers is that the interest isn’t immediately added to their principal balance. The bad news is that the interest doesn’t go away. The loan servicer keeps a tally of this unpaid interest. Once an event happens to trigger interest capitalization, the interest gets added to the principal balance. Interest capitalization is the accounting term used to describe adding unpaid interest to the principal balance. A larger principal balance means the loan generates even more interest each month.

Note for Borrowers on Income-Driven Repayment Plans: Borrowers on income-driven repayment plans may also receive a notice of unpaid interest if they are about to change repayment plans. Those who miss an IDR certification deadline automatically get put on the standard repayment plan.

Unpaid interest is only an issue for borrowers who have loans that generate more interest than their monthly payments. These borrowers should seriously consider the Revised Pay As You Earn Plan because of the interest subsidy available.

Is it a mistake to let unpaid interest capitalize?

Whether or not an unpaid interest payment makes sense will depend upon several circumstances.

In most cases, letting the unpaid interest capitalize is a reasonable option. Many borrowers will not be able to afford the large payment. Others will have more important priorities.

The one time letting unpaid interest capitalize is a mistake is for borrowers on an IDR plan. Don’t miss an income certification deadline.

Alternatives to making an unpaid interest payment

Money is a limited resource for most student loan borrowers. Making a sizeable unpaid interest payment means passing up other opportunities. Most borrowers will find one of the following options preferable to the unpaid interest payment.

• Emergency Fund – Even if you have massive amounts of student debt, all borrowers should have an emergency fund in place.
• High-Interest Loans – The point of making the unpaid interest payment is to avoid future interest charges. If you have a private loan with a higher interest rate, it is better to focus your efforts on attacking the high-interest debt.
• Saving for a House – Homeownership isn’t always the best financial move, but it is a priority for many. Saving for a down payment on a home is a reasonable alternative.

Loan Repayment Strategy

Unpaid interest shouldn’t really get treated differently than your student loan. Whether your loan balance is $8,000 or $8,500, the addition of the interest is unlikely to have a meaningful impact on your repayment goals. If you have the money to pay it down, it is great. If you don’t, that is fine too.

Even though the unpaid interest letter clearly says it isn’t a bill, many people mistakenly treat it as one. Stick to your plan. If you have private student loans or loans with higher interest rates, you probably want to focus on those items first.

If you are unsure which student loan you should attack, or what your strategy should be, these simple tips may help.

The post Should I Pay Off My Unpaid Interest Before It Capitalizes? appeared first on The Student Loan Sherpa.

Interest accrues daily, is billed monthly, but is only added to the principal balance after certain events.

I know that sounds like a complicated mess. By the end of this article, the student loan interest timeline will make more sense, and you will understand how to use this mess to your advantage.

Student Loan Interest Accrues Daily, But it Doesn’t Get Added to the Balance

Student loans generate interest every day.

Think of it like your electric bill. Every day you are using electricity. You don’t receive a daily bill. Yet at the end of the month, you can be certain you will receive a bill adding up each day’s expenses.

Student loans work similarly. Each day your lender is charging interest. Lenders and servicers may not show it on the student loan portal, but they are tracking it.

The Monthly Student Loan Bill

Each month your lender sends out a bill listing the interest charges for the month. That number isn’t based upon a monthly rate. Instead, it is the sum of the daily interest charges.

You may notice that months based upon a 31-day bill have higher interest charges than the months based upon a 30-day cycle.

Borrowers can utilize this fact by paying their student loan bills as early as possible. Waiting until the due date means the daily interest accrual is based upon a larger loan balance. Making payments a few days early means the balance will be slightly smaller for those few days. The difference in savings isn’t significant, but for larger balances, it can add up over the course of many years.

In most cases, the monthly payment is larger than the monthly interest. Borrowers in repayment will see their balance go down with each payment.

Borrowers who are not making payments, or who make payments smaller than the monthly interest, will see their balance go up.

Compounding Interest, Capitalized Interest, and Growing Student Debt Balances

The big danger with a growing student loan balance is that it can spiral out of control.

If the balance grows, more interest is charged. As more interest is generated, the balance grows even faster. Paying interest on the interest is known as compounding interest.

Fortunately, borrowers do not immediately start paying interest on the interest that accrues daily. In fact, federal student loan borrowers don’t even pay interest on the interest that is charged on each monthly bill.

Paying interest on the interest happens after capitalization. Interest is capitalized when it gets added to the principal balance of a loan.

Outstanding interest is the term federal servicers use to track the extra interest that has not yet been capitalized. Most federal servicer portals will show a borrower’s current balance, principal balance, and outstanding interest.

It is better to have federal student debt classified as outstanding interest because there isn’t a daily interest charge. Once capitalization happens, and the outstanding interest gets added to the principal balance, borrowers start paying interest on the interest.

As a result, interest capitalization can be very expensive for federal student loan borrowers. It is possible that a borrower could go years without having their loan capitalized. If an event triggers a capitalization, the principal balance could easily jump by thousands of dollars.

Avoiding Interest Capitalization on Federal Student Loans

In some cases, interest capitalization is unavoidable.

A common example of unavoidable interest capitalization is a borrower entering repayment after college. Federal direct consolidation also triggers interest capitalization.

Other times, responsible borrowers can avoid interest capitalization. For example, if you are on an income-driven repayment plan and miss your income certification deadline, you are automatically enrolled in the standard repayment plan. Changing repayment plans triggers interest capitalization. Thus, for borrowers on IDR plans, missing an income certification deadline could be very expensive.

Borrowers concerned about interest capitalization should review this article on avoiding capitalized interest on federal student loans.

Interest is the Enemy of Student Loan Repayment

The fight against student loan interest often leaves borrowers with two main strategies to efficiently eliminate their debt.

The borrowers who have increasing balances because they cannot keep up with interest should investigate the many options available for student loan forgiveness.

The borrowers knocking out their debt and fighting the daily interest should explore the strategies to get a lower student loan interest rate.

The post When Does Student Loan Interest Get Added to My Balance? appeared first on The Student Loan Sherpa.