The balance of a loan is made up of two major components: the principal, which is the amount borrowed, and the interest, which accrues regularly on the principal. Loan capitalization occurs when accrued and unpaid interest is added to the principal. This might happen once during the life of the loan when repayment starts, or at intervals, such as after deferment or on an annual basis.
Capitalization is most commonly found on student loans, although other types of loans might have capitalization. In order for a loan to be capitalized, it must have interest that accrues during a time when the borrower is not making any payments. Because it is common for students to defer payments while they are in school, the interest accrues on the balance and is capitalized before the student begins making regular payments.
Capitalizing interest on a loan increases the cost of repaying the loan. This is because the new principal balance is higher, and interest charges after capitalization are calculated based on the new principal balance. The borrower has to spend much of the monthly payment on not only paying off the higher balance after the capitalization, but also paying the extra interest on this higher balance.
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Say a student borrowed $3,000 at 6.8 percent interest to help pay for the freshman year of school. Every month, $17 in interest accrues on the loan. If the student is in school for three years and nine months, $765 of interest accrues on the loan balance during that time. In addition, $102 accrues during the six-month grace period following graduation. When repayment begins, the $867 of interest is added to the principal of $3,000, making the new principal balance $3,867. Now the monthly interest charge jumps to $21.91. On a 10-year repayment plan, the monthly principal and interest payment for $3,000 would have only been $34.52, whereas the payment for a balance of $3,867 is $44.50, which is 29 percent higher.
If you would like to avoid having unpaid interest added to your loan principal, pay it before capitalization. In the case of student loans, the interest is capitalized when your grace period ends, usually six months after you finish school. Make interest payments while you are in school or during your grace period to pay it off before it is capitalized. For example, if you borrowed $10,000 at 6.8 percent interest, monthly interest payments are $56.67. If you can afford to make these payments while you are in school, doing so will keep the amount you owe upon graduation to only the $10,000 you borrowed.