What Is Interest Capitalization?
Interest capitalization is the process by which unpaid interest on a loan is added to the principal balance. After that, interest is calculated on the larger amount, so you end up paying interest on interest. It is a feature of many student loans, and it can increase the total cost of borrowing without the borrower noticing.
How it works
Interest on many student loans accrues daily, whether or not you are making payments. If you do not pay accrued interest during periods such as school enrollment, a grace period, deferment or forbearance, it may build up. At certain points, specified in the loan terms, the unpaid interest is capitalized and becomes part of the principal.
Example. Suppose you owe $20,000 at 6 percent. Over a year of nonpayment, about $1,200 of interest accrues. If that is capitalized, the new principal is $21,200, and interest next year is calculated on that larger amount, about $1,272, instead of $1,200.
When it may happen
Triggers differ by loan type and by rules, which have changed over time. Examples include:
- End of a grace period after you leave school.
- End of a forbearance or, for some loans, deferment.
- Leaving certain repayment plans or failing to meet requirements.
- Loan consolidation or refinancing, where outstanding interest may be added to the new balance.
- Default in some cases.
Federal rules have been updated over the years, and some forms of capitalization were eliminated or limited, so check current guidance for federal loans. Private lenders set their own terms.
Ways to limit it
- Pay interest while in school if you can, even small amounts.
- Make payments during grace periods.
- Pay accrued interest during deferment or forbearance when possible.
- Choose repayment plans carefully, and understand what happens to interest.
- Ask your servicer when and how capitalization occurs.
- Consider paying extra toward interest first, if your servicer lets you direct payments.
Why it matters
Capitalization increases the total you repay, and may raise monthly payments. Understanding it helps you make informed decisions about when to pay and which options to use.
Related terms
See loan servicer, APR, compound interest, loan forgiveness and cosigner.
Frequently asked questions
When does interest capitalize?
It depends on the loan terms and, for federal loans, the rules at the time. Typical triggers include the end of a grace period or a forbearance, or leaving some repayment plans. Check your loan documents.
How can I avoid interest capitalization?
Pay interest as it accrues during school, grace periods and deferment or forbearance, where you can, so that it is not added to principal.
Is capitalized interest the same as compound interest?
It is a form of it. Interest is added to principal and then earns more interest, which increases the total cost over time.