It can be both scary and confusing to get a letter from your student loan servicer informing you that unpaid interest is about to capitalize.
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, but 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.