Capitalized Interest Leads to Bigger Loans
What does it mean to capitalize interest on a loan?
Capitalized interest is interest that you add to a loan balance, and you often see it with student loans and accounting practices.
With student loans, you can capitalize interest costs instead of paying the interest as it comes due. Because the interest charges go unpaid, the charges are added to your loan balance. As a result, the loan balance increases over time and you end up with a larger loan amount at graduation.
At some point, you’ll need to pay those interest charges. That happens in the form of higher monthly payments or payments that last longer than they would have otherwise lasted.
In accounting, capitalized interest is the total cost of interest for a project. Instead of charging the interest costs annually, the interest costs are treated as part of a long-term asset’s cost basis and depreciated over time.
Capitalizing Interest on Student Loans
With some loans, like student loans, you might have the option to temporarily skip payments on your loan.
For example, unsubsidized Stafford loans allow you to postpone payments until you finish school. That’s an attractive feature because it helps with your cash flow this month, but it might result in higher costs and tighter cash flow in the future.
Whether or not you make payments, interest is still accruing (or being charged against your loan balance).
You’ve borrowed money, so interest charges naturally follow. If you choose not to pay anything, your total loan balance when you finish school will be higher than the amount of money you actually received and spent.
Note that with subsidized loans, the federal government pays those interest costs, so your loan interest does not get capitalized.
Capitalized interest makes your loan balance grow. As a result, you’re not only borrowing what you originally borrowed for school and living expenses—you’re also borrowing to cover the interest costs. Because of that, you also have to pay interest on the interest your lender charged you.
Reverse compounding: Your loan balance will increase faster and faster as the amount of interest you “borrow” continues to increase. Paying interest on top of interest is a form of compounding, but it works out in your lender’s favor—not yours. Another term for this, which was a favorite loan feature before the mortgage crisis, is negative amortization.
Any payment helps: Even if you’re not required to pay anything, it’s best to pay something. For example, during forbearance or deferment, you might not have to make a full payment. But anything you put toward the loan will reduce the amount of interest that you capitalize. Your lender can provide information about how much interest is charged to your account each month. Pay at least that much so that you don’t go deeper into debt. Doing so puts you in a better position for the inevitable day when you have to start making larger “amortizing” monthly payments that pay down your debt.
As a student, you might not care if your loan balance increases each month. But a bigger loan balance will affect you in future years—possibly for many years to come. It also means you’ll pay more interest over the life of your loan.
The “cost” of a loan, ignoring any one-time fees, is the interest you pay. In other words, you repay what they gave you, and you pay a little extra. Your total cost is driven by:
- The amount you borrow: The higher your loan balance, the more interest you’ll pay.
- The interest rate: The higher the rate, the more expensive it is to borrow
- The amount of time you take to repay: If you take longer, there are more periods (months and years) during which your lender charges interest.
Especially with federal student loans, you might not have much control over the interest rate.
But you can control the amount you borrow, and you can prevent that amount from growing on you. But if you capitalize interest, your monthly payments (and lifetime interest costs) will be higher. How much higher? FinAid has a helpful calculator for running the numbers on deferment.
If you like to see how things work for yourself, you can also use a spreadsheet (Excel or Google Sheets, for example) to model your own loan. Just set the payments to zero for a sample deferment period.
Why Not Pay Extra?
Remember that your minimum required payment is just that—the minimum needed to prevent damage to your credit and late-payment fees. You can always pay more, and it’s often wise to do so. Paying extra on your debt helps you spend less on interest, eliminate debt faster, and qualify for larger loans with better terms in the future.