Student Loan Alert: Beware the Cost of Capitalization on Unsubsidized Staffords

Attention all college freshman, and returning students! If you have taken out an unsubsidized federal Stafford loan to help pay for college, I am betting you are making a big financial mistake.

My big question for you: Are you making the interest payments on the loan while you’re in school?

If you just answered no, that’s the big mistake. And to be honest, it’s an easy one to make.

The way loan repayments work is that you are not required to pay a dime while you are in school.  But if you go that route, the interest payments you aren’t making are added to your loan balance. This is called interest capitalization. So when you graduate, the amount you owe on the loan—your principal balance—is going to be higher than the original amount you borrowed.

For example, let’s say you're a college freshman this year and you have a $5,500 unsubsidized Stafford loan. All Staffords this year have a fixed 6.8% interest rate. If you don’t make any interest payments for four years, and then choose a 10 year repayment plan your balance at the start of repayment will be about $7,202 and by the time you make the last payment 10 years down the road, your total loan cost will have been nearly $9,950. If you instead pay the interest while in school, your all-in cost will be about $850 less. And that’s just for freshman year. If you continue to borrow each year, capitalization is going to pile up on you.

My advice: Do everything you can to pay the interest while you’re in school. On the $5,500 example here, that works out to about $63 a month. I bet you can figure out a way to handle saving about $2 a day. Or if family asks how they can help—suggest they help you avoid capitalization! You can plug in all your loan details into this Cost of Capitalization calculator to see how much you can save by paying interest while you’re in school.