Does Interest Capitalization Increase Loan Balance?
Uncover how accruing interest can enlarge your loan principal, leading to increased total costs and payments over time.
Interest capitalization directly affects a loan’s total balance. When interest capitalizes, accrued but unpaid interest is added to the loan’s principal amount. This increases the overall balance, which then becomes the new base for future interest calculations. As a result, borrowers pay interest on a larger sum than originally borrowed.
Understanding Interest Capitalization
Interest capitalization occurs when accrued, unpaid interest is formally added to the loan’s principal balance. This transforms unpaid interest into part of the new principal. For instance, if a loan has a principal of $10,000 and $500 in accrued interest capitalizes, the new principal balance becomes $10,500.
After capitalization, subsequent interest calculations are based on this increased principal amount. This means the borrower accrues interest not only on the original borrowed sum but also on the previously unpaid interest. This mechanism can lead to quicker growth of the loan balance, as interest is charged on interest.
Federal student loans generally use a simple interest method, meaning interest is calculated only on the principal balance. However, this principal balance can include previously capitalized interest.
When Capitalization Occurs
Interest capitalization frequently happens in specific lending scenarios, often when payments are temporarily paused or are insufficient to cover accruing interest. For student loans, this typically occurs after periods of non-payment, such as deferment or forbearance, or at the end of a grace period. For example, if a borrower defers an unsubsidized student loan, interest continues to accrue, and this unpaid interest is added to the principal when the deferment ends. This also applies to income-driven repayment plans if a borrower exits the plan, fails to recertify income, or no longer qualifies for a reduced payment.
In construction loans, interest that accrues during the building phase is often capitalized into the total project cost. This practice means the interest expense is added to the asset’s value rather than being expensed immediately. Capitalizing interest during active construction ensures that financing costs are reflected in the final asset value and can be depreciated over its useful life.
Another scenario is with deferred payment loans, where interest accrues from the outset but no payments are required for an initial period. At the conclusion of this period, the accumulated interest may be capitalized into the principal. Similarly, negative amortization occurs when scheduled loan payments are less than the interest accrued during a payment period. The unpaid portion of the interest is then added to the principal balance, causing the loan amount to increase despite regular payments. This can happen with certain types of mortgages.
Impact on Borrowers
Interest capitalization directly increases the total amount a borrower repays over the life of a loan. Because unpaid interest is added to the principal, the loan balance grows larger. This larger balance then serves as the base for future interest calculations, leading to a compounding effect where interest is charged on previously accrued interest.
This compounding can result in higher total borrowing costs than if interest were paid as it accrued. A larger principal balance often leads to increased monthly payments if the loan term remains constant. Alternatively, if monthly payments are kept steady, the loan repayment period may be extended, meaning the borrower remains in debt for a longer duration.
The financial burden on borrowers can intensify, particularly if their income has not increased to match rising loan payments. Paying at least the accruing interest during non-payment periods can help borrowers avoid or reduce the impact of capitalization.