What does pay mean on a statement?

What does the term "interest capitalization" mean in terms of loans (student loans in particular)?

• The grace period for my student loan is about to end, and I've found that the interest has accumulated since graduation until now. On my statement, Direct Loan says the following: "To avoid or reduce interest capitalization at the time of entering repayment, you can choose to pay all or a portion of your Total Unpaid Interest now. If you choose to pay later, please see the Payment Information section of this notice for more specific payment information." What does that mean? I have about $700 in interest plus the amount of money I'm expected to pay for my repayment plan starting next month. So what happens if I choose to start paying the interest down after I start repayment?

• Answer:

  From the day your loan was disbursed, until the day you make the final payment, interest accrues. While you were in school, and after graduation, while you were enjoying your grace period, you had no payment obligation, and the interest accrued, unpaid. There are two common ways for lenders to treat the interest that accrues while your loans are not in repayment; some lenders add the interest to the balance each month, as it becomes due, while other lenders let all the interest accrue, but only add it on, one time, when the loan actually enters the repayment phase. To the borrower, the second method would be greatly preferred - under method one, the balance grows every month, and each subsequent month's interest is based on a slightly higher balance. In effect, the borrower winds up paying a considerable amount of interest on the accruing interest itself. From what you've described, your interest capitalization method is that second, preferred method. Rather than adding on that interest every month, your lender has simply kept track of the interest that has accrued ($700) and they're ready to add it on now. They've given you the option to pay that interest off, right now - straight off the bat - and not have to worry about it later. If you have the $700 available now, and you don't need it for some other important purpose, it would be financially prudent to pay off all of the accrued interest right now. If you choose not to pay the interest now, the $700 will be added to your balance, and you'll find yourself in the position of a "method one" borrower, paying interest on that interest. Think of it this way - the lender has basically made you a loan of that $700 by not making you pay it as it accrued. You can pay it off now, as an interest-free loan, or you can fold that into your existing loan, in which case, you'll pay that $700 off, over the next 10 years, with interest. I hope that helped. Good luck!