Interest Capitalization

Interest capitalization summary:

• Interest capitalization occurs when unpaid interest is added to a loan balance, increasing the principal amount that's due. 

• Interest may go unpaid when loan payments are paused because a loan is put into deferment or forbearance, or when a borrower falls behind on loan payments. 

• When interest is capitalized, you'll have to pay interest on the interest, which makes your loan repayment more expensive. 

Interest Capitalization Definition and Meaning

Usually, when you take out a loan, you make payments that cover the interest on the debt and pay some of the principal balance each month. Principal is the amount you initially borrowed. 

However, sometimes you need to pause your payments. If lenders allow you to do that by putting your loan into deferment or forbearance, interest will usually continue to be charged while payments are paused. This also happens when you fall behind on your loan payments—interest charges continue to build up.

Lenders may decide to capitalize this past-due interest to bring your loan current. This can be helpful, since you won't have to play catch up with your missed or deferred payments, and it can prevent further damage to your credit rating. When a lender capitalizes your past-due interest, it rolls this amount into your principal balance. Your loan balance increases and you'll pay interest based on that higher balance.

Types of Interest Capitalization

Interest capitalization occurs most often in the context of student loans. If you take out loans, you don't usually have to make payments on the debt while you're in school. You also don't have to make payments for several months after graduation and can pause payments for other reasons during debt payback, such as active duty military service. 

With most student loans, except direct subsidized student loans, interest is charged from the time you get the loan funds. When your deferment period comes to an end, that interest capitalizes. 

Interest capitalization can also happen if you fall behind on a mortgage. Maybe you lost your job. Then, happily, you got a new job that allows you to resume your monthly payments but not pay extra to get caught up. Your lender may help you by capitalizing your past-due interest and bringing your account status to "current" on your credit report. Your new payment may be adjusted based on this higher balance and the remaining time on your mortgage, or your loan term might be extended.

Real-Life Example of Interest Capitalization

Here’s an example of interest capitalization and how it works from the Department of Education. 

You have a $10,000 direct unsubsidized loan, and each day, you owe around $1.86 in interest. 

When your loan payment is deferred for six months, you stop making interest payments, but during that period interest is still adding up. 

Over six months, a total of $340 in interest is charged. When your deferment ends, the unpaid $340 in interest capitalizes and is added to your loan balance. 

After loan deferment: 

Your new balance is $10,340. Now, with your larger balance, the amount of interest that you owe each day increases to $1.93 daily

Interest capitalization can help borrowers get past financial problems and back to repaying their loans as agreed. However, they pay interest on the interest that was added to the principal, so repayment becomes more expensive when capitalization happens.

You can avoid capitalization by making regular payments on your deferred loan that cover the interest, or by making a lump-sum payment for the total amount of unpaid interest due before the time capitalization would occur.