Are you paying off student loans or other debt? You might be surprised at how long it takes. Interest capitalization might be to blame. When you know what it is and how it works, you’ll be able to make greater strides toward financial freedom.
How does interest capitalization affect a loan? Here’s a closer look.
What Is Interest Capitalization in Simple Terms?
Interest on a loan builds up over time. If you don’t pay it as it accrues, the unpaid interest is added to your principal—the amount you originally borrowed.
Once that happens, future interest is calculated on the higher balance. In other words, you start paying interest on interest.
So, is capitalized interest good or bad? For borrowers, it usually means higher total costs over the life of the loan.
Is Capitalized Interest the Same as Compound Interest?
Capitalized interest is similar to compound interest—both increase what you owe—but they work in different ways.
- Capitalization is a one-time event. Unpaid interest is added to your principal, increasing your loan balance at specific times.
- Compounding, on the other hand, is an ongoing process. Interest is calculated on both the principal and any previously accrued interest, causing your balance to grow continuously.
Timing is the key difference. Capitalization happens at set moments, such as when a student loan grace period ends and unpaid interest is added to the balance.
Compounding typically happens daily or monthly. For example, most credit cards compound interest daily, which can cause balances to grow much faster than one-time capitalization events.
When Is Interest Capitalized?
To avoid unexpected increases in your loan balance, it helps to know when interest is capitalized. The timing varies by loan type, but here are some common scenarios:
Student Loans
With subsidized loans, interest usually capitalizes at the end of a forbearance period. Forbearance is when your lender lets you pause payments due to hardship.
Unsubsidized federal loans may capitalize interest more often. That’s because interest accrues on these loans during deferment. You usually don’t have to start repaying while still in school, but interest builds during this time.
If you’re in an income-driven repayment plan (IDR) and drop out, interest may capitalize then, too.
Home Equity Lines of Credit (HELOCs)
HELOCs are different from most lines of credit. They usually involve two periods:
- Draw Period (5 to 10 Years): You withdraw funds and make low payments.
- Repayment Period (10 to 20 Years): You stop withdrawing and start repaying.
With a HELOC, interest often capitalizes after the draw period. Paying interest before the period ends saves you money. If you have to pause payments, interest will likely capitalize when the pause ends.
Mortgages
Capitalization isn’t common with mortgages. But it can happen sometimes. The best example is the negative amortization mortgage.
With this mortgage, payments don’t always cover all the interest. That interest capitalizes, increasing what you owe.
Like with other types of loans, mortgage interest can also capitalize at the end of a payment pause.
Car Loans
With a car loan, interest won’t usually capitalize. But what if you need to pause payments? If you miss payments or your lender pauses them, interest will compound.
How Much Does Interest Capitalization Increase Your Total Balance?
Does interest capitalization increase the loan balance? The answer is yes.
Interest capitalization increases your loan balance, which means you’ll pay more over time.
Here’s a simple example. Say you have a $20,000 student loan with a 7% interest rate. You pause payments for two years and don’t cover the interest as it accrues.
At the end of that period, you’ve built up about $2,801 in unpaid interest. Once it capitalizes, your new balance becomes $22,801. Future interest is now calculated on that higher amount.
The impact grows with larger loans. Take a $400,000 mortgage at a 5% interest rate. If you pause payments for two years and let interest accrue, you’d add roughly $40,001 to your balance. After capitalization, you’re paying interest on more than $440,000. That higher starting balance can significantly increase the total cost of the loan.
How Can You Avoid or Reduce Capitalized Interest?
Want to find out how to avoid interest capitalization? These tips may help:
- Pay interest early
- Make payments during forbearance (if you can)
- Keep your payment pauses to a minimum
- Consider refinancing for a lower rate
If you can make more than the minimum payment on some loans (like HELOCs), that may also help reduce what you owe.
Why Understanding Capitalization of Interest Matters
When paying off loans, many people only think about monthly payments. However, knowing how interest works saves money in the long run. Taking time to learn about interest capitalization can help you get out of debt faster.
