Paying back a loan sounds like a straightforward task. You make regular payments and watch your balance go down, right? Enter “Interest Capitalization.”
In some situations, the interest charged on your loan can increase the amount owed. Here’s how it works. When you take out a student loan (or a mortgage), interest starts accruing right after it’s disbursed. Some lenders extend a grace period of 6 months after graduation before demanding payment. So even though you don’t have to start paying it back yet, your balance is increasing. This also happens when you defer or miss payments which adds a late fee to your overall loan balance. Managing Your Total Loan Balance
As your loan becomes due, your lender will capitalize your interest (add the accrued interest to the original balance). Let’s take this example; if you borrowed $2,000 at a 6% interest rate, due 6 months after graduation. By that time, the interest will have accrued for 54months at $10 per month. That’s $540 that will be added to your balance, resulting in $2,540 in total debt.
However, If you paid off the accrued interest every month, the lender can’t capitalize it. The loan balance at the beginning of your repayment period remains the original $2,000. Paying this amount over a standard 10-year repayment period will be cheaper than with the capitalized interest.
Remember that this is repeated for every student loan you take, so imagine the savings you’ll pocket by making interest-only payments during your student tenure.
With that being said, this is not the only way your loan balance can increase. This post elaborates on other causes that may result in your loan increasing.
The Income-Driven Payment Plan
Unlike a standard repayment plan with a set schedule, an income-driven payment plan derives your monthly payment as a percentage of your annual income. On a standard payment plan, the monthly payment goes towards the interest accrued from the last payment, and the rest goes towards your principal. However, on an income-driven plan, it is possible that your balance continues to increase as the new payment will not be enough to cover the accrued monthly interest.
