Loan Capitalization

Author  Joe Chappius

Last updated: December 11, 2024

The term “capitalization”, when applied to loans, might sound a bit intimidating. But it’s a straightforward concept that has a real impact on the total cost of your borrowing. This article breaks down capitalization and how it relates to your financial responsibilities.

What is Capitalization?

Capitalization is the process of adding unpaid interest to the principal balance of your loan. The principal is the original sum you borrowed. When interest isn’t paid on time, it may be capitalized, meaning it becomes part of that principal balance.

Why Does This Matter?

Capitalization is important because once your unpaid interest is added to the principal, you start paying interest on that interest, increasing the overall cost of your loan. Essentially, you’re paying interest on a larger amount.

When Does Capitalization Occur?

Capitalization of interest on loans generally happens in a few key situations:

• Unsubsidized Student Loans: Interest continues to accrue during deferment or forbearance, regardless of whether you’re making payments. At the end of those periods, any unpaid interest can capitalize. Subsidized loans, on the other hand, receive interest subsidies (paid by the government) during certain qualifying periods, which lowers the likelihood of capitalization.
• Income-Driven Repayment (IDR) Plans: Some IDR plans for federal student loans subsidize unpaid interest if your income is eligible. If you change out of these plans or no longer qualify, unpaid accrued interest could be capitalized.
• Missed or Late Payments: This varies depending on the type of loan. With some mortgages or personal loans, lenders may capitalize unpaid interest from late or missed payments, increasing your balance.
• Loan Modification: If you undergo a mortgage loan modification, unpaid interest might be capitalized into a new principal balance.

How Does Capitalization Influence Repayment?

Here’s how capitalization can affect your loan:

• Increased Principal Balance: Your loan balance grows, leading to a longer overall repayment term.
• Higher Monthly Payments: In many cases, increased principal leads to higher monthly payments.
• Greater Total Loan Cost: You’ll end up paying more overall in interest for the loan’s lifetime.

Examples of Capitalization

To make the concept of capitalization crystal clear, here are some practical examples:

• Student Loan Scenario: You graduate with $20,000 in unsubsidized student loans at a 6% interest rate. During graduate school, you place those loans into deferment for two years. During those two years, approximately $2,400 in interest accrues. Upon exiting deferment, that $2,400 is capitalized, making your new principal balance $22,400. You now owe interest on a larger amount.
• Mortgage Scenario: Let’s say you miss a mortgage payment, and your lender charges you $300 in late fees and unpaid interest. This $300 is capitalized, meaning it’s added to your mortgage balance. Going forward, you’ll be charged interest on that added late fee/interest amount.

Capitalization vs. Accrual

Understanding the difference between interest capitalization and interest accrual is important:

• Accrual: Accrual is the regular accumulation of interest that occurs on your loan. Think of it as a meter constantly running, adding interest charges over time.
• Capitalization: Capitalization is the specific event where unpaid, accrued interest gets added to your loan’s principal. It’s like hitting a “reset” button on the accrual meter, but this reset makes your overall loan more expensive.

Minimizing the Effects of Capitalization

While capitalization can increase your loan cost, there are proactive steps you can take to lessen its impact:

• Make Interest-Only Payments (If Possible): During periods of deferment, forbearance, or when struggling financially, try making payments that cover at least the accrued interest each month. This prevents significant growth in your principal balance due to capitalization.
• Explore Income-Driven Repayment (IDR) Plans: If you have federal student loans, specific IDR plans subsidize a portion of any unpaid interest. This means the unpaid interest is less likely to capitalize, even when payment pauses occur.
• Consider Loan Consolidation: Consolidating federal student loans before unpaid interest capitalizes can essentially reset your loan to the original principal balance. However, carefully research whether direct consolidation is right for you, as weighted-average interest rates might apply.
• Contact Your Lender Proactively: If you know you will have trouble making upcoming payments, reach out to your lender before payments are missed. Many lenders have options or hardship programs to help navigate challenging situations that could potentially prevent capitalization.

Important: Not all of these strategies will apply to every loan type. Carefully review your specific loan terms and contact your loan servicer or lender for the most accurate advice.

Frequently Asked Questions