Student Loans: Accrued vs Capitalized Interest

All right, associates, welcome back. We're going to talk now, continuing on the segment of basic definitions about accrued interest and capitalized interest. These are not the same things and sometimes you'll hear them used interchangeably. Important to know the difference between them. So let's go, let's, let's go into this. Let's look an example where you are out of school year two and you're earning $150,000 as an associate. You have $500,000 of student loans and your rate is 6.8% and your term is 10 years. You'll notice I've got the start of two tables. One is in accrued, where we're showing accrued interest. The second one is where we're showing capitalized interest. Let's start off on accrued interest. Let's look at year one. In year one.

You have a total payment or you can see at least how it's broken up. Actually, let me start on the left. You see the payment there? 10% of your income is $15,000. Why am I using 10%? Because I'm going to assume for a second that you're on an income driven repayment plan or an idr, such as ibr, income based repayment pay, pay as you earn or repay revised pay as you earn, and all of those. Unless you had an IBR that predates 2014, I'm going to assume you don't have a 10% of cap on your income. Now, I'm going to explain exactly how that's calculated a little bit later. But for now, let's just keep it simple. 10% of 150,000 is 15,000. And so in year one, the government is saying, hey, borrower, you're not going to have to pay more than $15,000 on your student loans for the whole year. Now, when you come out of dental school, though, right? When you come out and you're now working, and what the government does is they say your standard plan, repayment plan is a 10 year repayment plan, 10 years. And as you can see up there, we have a standard term of 10 years at 6.8%. Now, if you were to actually pay that, you would be paying total principal for the year of $36,532.04 and then interest $34,000 during that first year. So if you add that up roughly around $70,000 and a little bit more, and you're thinking, sheesh, I could never pay that right now. Well, you don't have to because again, you're limited to 10% of your income, which is $15,000. Now notice that your $15,000 is less than either the principal portion and the interest portion. Now where do you think the government's going to apply that $15,000? You got it? I hope you said it. Interest. They're going to apply that $15,000 toward interest first. So if you keep going to the right, you didn't pay a dollar in principal because you didn't even pay enough to cover your $34,000 of interest. So not a dollar of principal did you pay.

So the actual interest you paid was $15,000 and that's your actual interest. The remainder of the interest, which is the $34,000 of total interest less what you actually paid at $15,000 equals $19,000. And we're explaining accrued interest. So that's accrued interest, that's interest that you did not pay. And guess what happens to it? Yes, it goes, it gets added to the balance of your loan, which you can see if you continue right on the table. The balance of your loan at the start was $500,000. Well, at the end of year one, it's now $519,000 because you didn't pay $19,000 of interest. So now at the beginning of year two, your balance is $519,000. Now, your interest rate was 6.8%. Now you see on the right it says your true interest rate was 6.55. That's only because in my simple schedule I am annualizing this where in reality you'd be paying every single month for the year. And your true rate is 6.8% for that first year. Now let's go to year two. In year two again, you're making 150,000. So you're not going to pay more than 15,000 bucks. And the rate, the amount you would Pay on a 10 year standard is still the same 36532.04. And your interest still the same $34,000 because it's your interest rate applied to the original balance of 500,000, not the balance of 519,000. So it all looks almost identical as you continue right on the table. Your actual interest was 15,000. That's what you came out of pocket with, was $15,000 for the year it all went toward interest and you accrued another $19,000 of unpaid interest. It accrued or got tacked onto the balance at the end of last year, which was 519. So now it's 519 plus another 19. So it's 538,000. Notice, though, that your interest rate dropped because you still paid the same amount of interest on a larger balance. So if you paid the same amount of interest on a larger balance, that means you paid a lower rate. Now, what happens when you go to year three? The same thing. $15,000. Total interest is still 34,000. You only pay 15 of that, so 19 gets accrued. You're now at 557,000. And again, your true rate dropped down to 6.1% because your balance got higher, but you paid the same interest, which means your interest rate effectively dropped year 10. So I'm skipping forward seven years and look all the way to the right. Your balance is now at $690,000, and your rate for that year was effectively 4.93%. Skip forward to 20 years, and on that 20th year, your balance has now gone up by 8, up to 880,000, because you've been tacking on $19,000 every year. But look at your rate. It's at 3.86%. Why? Because your interest was calculated using a balance of 20 years ago at 500,000 instead of 880,000. So your rate effectively goes down every year under a standard accrued interest. Now, student loans, the default is. The default is, is that your interest is.

An accrued interest. That said, there are some things that will cause it to be capitalized. Now, let's talk about what capitalized interest is. So let's look at the same structure. Year one, guess what? It's all the same. You can look up above and you'll see every number is the same. At the end of year one, your balance is $519,000. The difference starts to surface in year two, because now the interest over in the total interest column, column number four, notice that that has gone up. And do you know why that's gone up? It's because your 6.8% is now applied to the ending balance of last year, 519,000. It's not applied to 500. It's applied to $519,000. And so therefore, the amount of interest went up from 34,000 to 35,292. All the while, you're still paying 15,000 bucks. That's 10% of your annual income. So the amount of pain you experience from paying doesn't change. But the amount of pain you experience from logging into studentaid.gov and looking at your balance, that starts to rise because your balance is now higher after year two under the capitalized interest model than it was under the accrued interest model. And let's go to year three, same thing. Now you paid $36,671.86 of interest. That's column four.

Because the balance you paid on was 539,292, the ending balance of the prior period. And now we go down to year 10, skipping a few notice that you paid $49,000, 347.

In year 10 because you're paying that interest of 6.8% on the ending balance of the prior year, which I don't show that here because it's year nine. But that's caused your interest from year 10, 49, 3, 47, to go way up from your first year where it was only 34. So 34 up to 49, you're talking about over $15,000 more you paid in year 10 in interest than in year one. Now, I say you paid, theoretically, if your income was the same every single year at 150,000, you're not paying any more. But notice the balance is a lot higher. And also notice that your true interest rate is staying pretty much the same. Why? Because the interest rate really doesn't change. The interest rate is being applied to your running balance every year under the model up above the accrued, your interest rate is always applied to that beginning balance of 500,000. So we skip all the way forward to year number 20. And in year 20, you're still making 150,000 bucks. You still paid $15,000. Now you paid interest in that year of $81,000. 314 maybe didn't pay it. It got accrued, it got capitalized, got added to the balance of the loan. And that is what capitalized interest is. It's when the interest gets added to the balance of the loan, and then that new addition has interest charged on it as well as the original balance. So your rate stays, you can see in the right column, the same pretty much every year throughout that entire schedule. So what's the bottom line here? The bottom line is that accrued interest is simple interest. Maybe you've heard of that before, gone through it in some other class or a math class, perhaps at some point. Accrued interest is simple interest. The interest rate every year is always the same. It's multiplied by the first year balance, and that never changes. But capitalized interest is compound interest. It's interest that charges interest on itself. Let's look at a diagram. I like to think of these as two separate buckets that accrued Interest is as every year goes on and you don't pay the minimum amount needed for just to cover your interest on your 10 year standard loan. Had you been on a 10 year standard loan, which is what the government sort of defaults you at as you come out of dental school, then that gets put, that interest gets put, that simple interest or accrued interest, it gets put put into bucket number one and it just sort of stays there. But there are certain things that will take bucket number one and empty it or a portion of it into bucket number two. And now it becomes capitalized interest and future interest is charged on that interest. What events cause bucket number one to pour into bucket number two? And remember, it's not like all of bucket number one pours in there. It's just the portion of the interest that goes into bucket number one that relates to a certain event. And let's look at those events. What triggers or causes accrued interest to capitalize?

Well, here's our list. Number one, your grace period ends on unsubsidized loans. Remember that your unsubsidized loans are your graduate, typically your graduate loans, your dental school loans. And when you come out of your dental school, you have this grace period, short period of time where you don't have to make your payments yet, but the interest is accruing whether you pay or not. And under an IBR or pay or repay program, you're at 10% of your income would go toward principal, but when you're not even working, you have zero going toward paying the interest. So the full interest portion, in my latter example, that would have been $34,000, the full interest portion will build up. And then right as you come out of school and your grace period ends and now it converts into a paying student loan, then that interest that built up while you were in dental school capitalizes and you will pay interest on that interest. Number two is if you go into forbearance, which is something I don't like, but if you go into forbearance, that period of time where interest is building up, when you come out of forbearance, that interest gets added to the balance of your loan and you now have to pay interest on that portion of interest that built up while you were on forbearance, number three is your deferment on unsubsidized loans ends. So if you go in deferment, we're going to talk more in a separate module. The difference between forbearance and deferment, what whys and whens. But if you're on a deferment, which is a little bit softer than forbearance, but if you're on deferment and you have unsubsidized loans, which you will, as you come out of deferment, that interest that accrued while you were on deferment and now capitalizes and you'll pay interest on that interest. Here's one that's really important. If you switch IDR plans, IDR Income Driven Repayment Plan, that's IBR pay, repay and what's called icr. If you're a few years into one, you decide to switch to the other. Whatever capitalized interest, whatever interest built up during that period of time suddenly gets tacked onto the balance of the loan and now you're paying interest on that. Now you may think that as your interest accrues that it's being tacked onto the balance of your loan. It feels that way. But in reality you got to think of accrued interest as sort of interest that's setting up over here and here's your balance. And then suddenly you do one of these things and it causes you to capitalize. Then it gets added, truly added to the balance of the loan because now you're paying interest on the whole thing. The next one is, and by the way, we're going to talk a lot more about IDR plans. And ideally you want to get that set up and set up right at the beginning so you don't have to switch IDR plans and possibly cause a capitalization of your interest. The next one. You, you don't recertify your income annually. Yes, the government will penalize you by capitalizing your interest if you don't let them know through your annual certification what your income is. And there's a form that you have to submit to do that. So really important to do that every year. Next is if you no longer qualify to make payments under Pay and IBR, not repay, but pay and Ibrahim, meaning that your income got so high that 10% of your income is now higher than a standard 10 year repayment plan. You basically no longer qualify to make payments under a pay and an IBR arrangement. It's called a hardship. You're no longer suffering a hardship. And if that happens, then at that point all the interest that you accrued up to that point, something gets tacked onto the balance of your loans and now you'll pay interest on that interest. And so the balance of your loan could go up. But if you're making that much now then, but if you're on Payor or IBR, you still don't have to pay more than 10%. You can still paying 10%, but you're going to see the balance of your loan start to go up a lot faster because now your interest is capitalized and you're paying interest on your interest. And lastly, when you consolidate your federal loan, so at the point of consolidation, whatever accrued interest built up prior to that point now gets added to the balance of your loan for purposes of calculating interest on your loan. Really important subject. I hope you hung in there, understood those concepts, followed my amortization scheduled. What's the bottom line? The bottom line is, as you come out of school, let's get the right plan and let's try to stick with that right plan. Either as you, as you pay off your student loans with a goal of I'm going to get out of student debt, which is what I'm going to recommend. And if you work for practice cfo, we are aggressive on you becoming financially independent. And if you're going to say I'm going to have my student loans forgiven after 20 years or 25 years, that's not the right mindset to me because you're saying I want to keep my income low enough such that 10% of my income is allows me to stay or keep my student loan payments low. I'd rather have you making excellent money because you run a great business, a great practice, you treat your patients the right way and you have great charisma with your team and you're a great leader and you get out of your debt and imagine when that's gone. And I've had many young dentists who have had that sort of mentality and they pay it off. It is a beautiful moment. It's like Andy Dufresne just crawling out of that pipe into that river in Shawshank Redemption, raising his hands to the sky and just feeling free. Well, that's how you feel coming out and paying off your student loans. So we got so much more to cover. I'm excited about it. Hang in there. Stay tuned and we'll carry on.