What To Do About Student Loan Interest Capitalization

If you're currently in college and have student loans, you may have recently received one or more quarterly interest statements from Direct Loans. Current students are given the option to delay their monthly payments until they're finished with school, though interest may have already began to accrue. This accrued and unpaid interest is what this form details.

Statements will show a current balance along with a figure for Total Unpaid Interest. Though this is not an actual bill, it looks a lot like one because of the clear bold figure indicating how much you might want to pay and the inclusion of a pre-addressed envelope and remittance form. So should you pay it?

The short answer: Yes, you should probably pay it.

Unless you absolutely cannot afford it or if you have debt with a considerably higher interest rate than the student loan, I'd like to see you pay all of the Unpaid Interest. Basically, unless you're dead broke, have high-interest credit card balances, or if you've got a loan shark chasing after you, grab your purse and start writing a check to the U.S. Department of Education.

Here's why: If you make a payment toward this loan -- especially if it's only for the listed amount on the form -- you're going to decrease your tax liability for the current year. If you're in the 25% tax bracket and you have $100 in unpaid interest, a payment of $100 will increase the size of your refund by $25 even if you're using the standard deduction. This $25 far outweighs how much you would save in interest by sending that same $100 to a loan with a slightly higher interest rate that is not tax deductible.

My wife just received a quarterly interest statement for her student loans. Because she's enrolled in grad school, no payment is due at this time. Currently, the interest rate on her student loans is about 1% less than the rate on our auto loan. So I considered letting it ride on the student loan interest and making a larger payment this month on our auto loan. But because the interest on an auto loan is not tax deductible, even with its higher rate it makes sense to pay the Total Unpaid Interest on the tax-deductible student loan.

But keep this in mind: If you have debt with a higher interest rate than your student loans -- like an auto loan -- only pay the Total Unpaid Interest on your student loan, and never more. Payments toward principal-only should always be made to loans with the highest interest rate.

If you don't have an auto loan or credit card balances, consider paying the Unpaid Interest plus whatever extra principal you can afford on your student loan. But if you have more than one federal student loan and receive multiple corresponding quarterly interest statements, don't pay extra principal on a loan until you have paid the unpaid interest on all of your student loans, regardless of their interest rates. Any payment amounts that exceed the Total Unpaid Interest will go toward the principal balance, which is not considered tax deductible. If you can afford to pay more than the Total Unpaid Interest on all of your loans, first, write a separate check for each account's Total Unpaid Interest, and then write an additional check for the account with the highest interest rate (probably a PLUS loan) in the amount of your extra principal payment.

If you're a student and you don't have any credit card debt or a high-interest auto loan, pat yourself on the back!