Definition and Examples of Capitalized Interest
When unpaid interest is capitalized, it's added to the balance of the loan. Capitalized interest makes your loan balance grow larger. As a result, you’re not only borrowing the original loan amount, 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.
Your loan balance will grow 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.
- Alternate name: Negative amortization
- Alternate definition: 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.
For example, suppose you borrow $20,000 in student loans. The interest rate is 4%. Interest accrues each year you're in school, so that you owe $2,095 in interest plus the $20,000 in principal by the time you graduate in four years. After a six-month grace period, during which time you paid nothing on your loan, the interest is capitalized, meaning it is added to the principal. Your new loan balance is $22,095. Now when the lender calculates the interest owed, it uses $22,095 as the principal amount, not $20,000. That increases the amount of interest you owe going forward.
How Does Capitalized Interest Work?
With some loans, such as student loans, you might have the option to skip payments on your loan temporarily.
For example, Unsubsidized Direct loans allow you to postpone payments until you finish school. That’s an attractive feature because it helps with your cash flow while you're going to school. However, it might result in higher costs and tighter cash flow in the future.
When you take out student loans, your lender may capitalize interest costs at the end of a deferment or forbearance. Instead of paying the interest as it comes due, you can let costs build up. Because the interest charges go unpaid, the charges get 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.
The most important thing to know is that you need to pay capitalized interest charges at some point, and you will pay additional interest when you capitalize. This change happens in the form of higher monthly payments or payments that last longer than they would have otherwise.
After March 2020 and with the relief measures taken during the pandemic, many financial institutions are using capitalized interest within the framework of the forbearance granted to millions of mortgages, car loans, credit cards, and many other types of loans.
This relieves cash flow pressure from borrowers but creates higher debt obligations in the future.
With subsidized loans, the federal government pays your interest costs when you defer, so your loan interest does not get capitalized.
What It Means for Your Loan Repayment
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.
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.
How Much It Will Cost
The cost of a loan, ignoring any one-time fees, is the interest you pay. In other words, you repay what they gave you, plus 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 the loan: If you take longer to pay, there's more time for your lender to charge interest.
You might not have much control over the interest rate, especially with federal student loans. But you can control the amount you borrow, and you can prevent that amount from growing on you.
If you capitalize the interest, your monthly payments (and lifetime interest costs) will be higher.
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.
If you like to see how the numbers work for yourself, you can use a spreadsheet (Excel or Google Sheets, for example) to model your loan. Just set the payments to zero for a sample deferment period.
- Capitalized interest is interest that is added to a loan balance, increasing both the balance and the eventual interest due.
- Often, capitalized interest is seen with student loans.
- When a borrower delays paying the interest and the lender capitalizes it, the monthly payments may be larger and lifetime interest costs will be higher.