Capitalization (loans)

What is Capitalization?

Capitalization is the addition of unpaid interest to the principal balance of a loan. This practice occurs when the borrower does not make interest payments that are due during a specific period. Instead, the unpaid interest is added to the principal balance of the loan.

Capitalization (loans) Defined

When the interest is not paid as it accrues during periods of in-school status, the grace period, deferment, or forbearance, your lender may capitalize the interest. This increases the outstanding principal amount due on the loan and may cause your monthly payment amount to increase. Interest is then charged on that higher principal balance, increasing the overall cost of the loan.

  1. Accrual of Interest: In most loan agreements, interest accrues on the loan’s outstanding balance over time. For example, if you have a $10,000 loan with an annual interest rate of 5%, you would accrue $500 in interest for the year.
  2. Scheduled Payments: Typically, borrowers are required to make periodic payments to cover both the interest charges and a portion of the principal balance. These payments ensure that the loan is gradually paid off over time.
  3. Capitalization: If a borrower fails to make interest payments when they are due, the unpaid interest may be capitalized, meaning it is added to the principal balance of the loan. As a result, the outstanding loan balance increases, and future interest charges are calculated based on the higher balance.
  4. Effects on Total Debt: Capitalization of interest effectively increases the total amount owed on the loan. This can result in higher monthly payments or an extended repayment period, as borrowers may need to pay interest on both the original principal balance and the capitalized interest.
  5. Impact on Borrowers: Capitalization of interest can have financial implications for borrowers. It may lead to higher total interest costs over the life of the loan, as borrowers are effectively paying interest on interest. Additionally, if the loan term is extended due to capitalization, borrowers may remain in debt for longer, potentially affecting their financial stability and long-term financial goals.

Capitalization Example

Let’s consider a student loan with a principal balance of $20,000 and an annual interest rate of 6%. Suppose the borrower enters a deferment period, during which no payments are required, and interest continues to accrue.

  • Accrued Interest: Interest accrues on the outstanding balance of the loan over the deferment period. If the deferment period lasts one year, the accrued interest would be $20,000 × 6% = $1,200.
  • Capitalization: At the end of the deferment period, the $1,200 in accrued interest is added to the loan’s principal balance, increasing it to $21,200. The borrower now owes interest on the higher balance, potentially leading to higher monthly payments or an extended repayment period.

Capitalization with loans is a common practice in various types of lending, including student loans, mortgages, and personal loans. Borrowers should carefully review their loan agreements and understand the implications of capitalization on their overall debt and repayment obligations.