What does it mean to capitalize interest on a loan?
Capitalized interest is interest that you add to a loan balance. Instead of paying the interest as it comes due, the interest charges go unpaid, resulting in a higher loan amount. At some point, the interest will need to be repaid – in the form of higher monthly payments or payments that last longer than they would have otherwise lasted.
Basics of Capitalizing
With certain loans (like student loans), you might have the option to temporarily skip payments on your loan.
This is tempting because it helps with your cash flow this month, but it might result in higher costs and tighter cash flow in the future.
For example, with unsubsidized Stafford loans, you might be able to postpone making any payments until you finish school. However, interest is still accruing – you’ve borrowed money and you’ve got interest charges on that loan. 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.
With subsidized loans, the federal government pays those interest costs, so your loan interest does not get capitalized.
Capitalized interest makes your loan balance get bigger. As a result, you’re not only borrowing what you originally borrowed – you’re also borrowing to cover the interest costs, which means that you’ll have to pay interest on the interest you borrowed.
In other words, 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 popular before the mortgage crisis, is negative amortization.
Even if you don’t have 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 towards the loan will reduce the amount of interest that you capitalize. Your lender will provide information about how much interest is charged to you each month – pay at least that much so that you don’t go deeper into debt. This is good practice for the inevitable day when you’ll have to start making larger “amortizing” monthly payments that pay down your debt.
Right now, you might not care if your loan balance increases each month, but that higher 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 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 during which you’ll be charged 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: if you capitalize interest, your monthly payments (and lifetime interest costs) will be higher. How much higher? FinAid has a nice calculator for running the numbers.
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.
Remember that your minimum required payment is just that – the minimum required to keep you from damaging your credit and paying 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 better loans in the future.