When taking out a loan, especially for large expenses like student loans or mortgages, you might come across the term “capitalized interest.”
Capitalized interest can significantly affect the overall cost of your loan, but it’s often misunderstood by borrowers. In this article, we’ll explain what capitalized interest is, how it works, and how it can impact your loan balance over time.
1. What is capitalized interest?
Capitalized interest is unpaid interest that is added to the principal balance of your loan. When this happens, you’re essentially paying interest on the original loan amount as well as on the unpaid interest, which increases the total cost of the loan.
This typically occurs when borrowers are allowed to defer payments, such as during a grace period or while still in school for student loans. Once the deferment period ends, any unpaid interest is capitalized and added to the loan balance.
2. How does capitalized interest work?
Let’s say you have a student loan, and while you’re in school, the interest on your loan accrues but you aren’t required to make payments yet.
Once you graduate or the deferment period ends, the accrued interest is added to your loan’s principal. Going forward, your loan payments will be based on this new, higher balance, which means you’ll end up paying more interest over time.
For example, if you borrowed $10,000 at a 5% interest rate and accrued $500 in interest during the deferment period, that $500 would be capitalized. Your new loan balance would be $10,500, and interest would now be calculated based on this larger amount.
3. When does interest capitalization happen?
Interest capitalization typically occurs in specific situations, such as:
- End of deferment or forbearance: If you’ve postponed loan payments during deferment (for student loans) or forbearance (for mortgages), the unpaid interest accrued during this period is capitalized when you start making payments again.
- Missed payments: If you fall behind on payments or enter into a repayment plan where interest is allowed to accrue, it may be capitalized after a certain period.
- Loan consolidation: When you consolidate multiple loans into one, any outstanding interest is often capitalized and added to the new loan’s balance.
4. How does capitalized interest affect your loan?
The biggest impact of capitalized interest is that it increases the total cost of your loan. Because your loan balance increases when interest is capitalized, you end up paying more in interest over the life of the loan.
Additionally, since your monthly payments are often calculated based on the principal balance, having capitalized interest means you’ll likely face higher monthly payments moving forward.
5. How to avoid or minimize capitalized interest
While capitalized interest can’t always be avoided, there are strategies you can use to minimize its impact:
- Make interest payments during deferment: Even if you’re not required to make full payments during a deferment or grace period, paying off the interest as it accrues can prevent it from being capitalized later.
- Stay current on payments: Avoid missed payments to prevent unnecessary capitalization of interest. Enroll in automatic payments if possible to ensure you never miss a due date.
- Choose the right repayment plan: If you’re on an income-driven repayment plan, be aware of how your interest is handled. In some cases, switching to a plan that doesn’t allow interest to build up can help reduce the total cost.
Capitalized interest can add to the overall cost of your loan, making it important to understand how it works and when it happens.
By paying attention to periods of deferment, forbearance, or missed payments, and by taking steps to manage unpaid interest, you can minimize the effects of capitalized interest and save money over the life of your loan.
Being proactive with your loan payments can make a significant difference in how much you ultimately pay.