Interest capitalization occurs when a lender allows a borrower to defer paying interest on a loan, resulting in an increase in the final amount owed on the loan. It is common in student loans and construction loans, and borrowers can avoid it by making interest-only payments.
Capitalization of interest occurs when a lender allows a borrower to defer paying interest on a loan. The interest that accrues during that time is added to the loan balance. Interest compounding typically occurs with student loans, as well as construction or real estate loans. The lender will inform the borrower in advance how the interest process will work; In some cases, it will be necessary to apply for a loan deferment to postpone interest payments.
In construction, this interest is considered an asset, since the final loan must include all costs incurred to build the property. This occurs because a loan is typically issued for construction purposes long before payment begins or construction is complete, so interest may be deferred and capitalized into the final loan. Typically, interest capitalization will not occur until the borrower begins to repay the loan. Interest will accrue on the loan, even if it is not yet repaid, but the borrower is often free to make an interest-only payment to avoid interest compounding. Although this process can be seen as a convenient way to avoid making loan payments for a period of time, it also has drawbacks.
Capitalization of interest increases the final amount owed on the loan, and also increases the amount that will be paid over time. This is because, in most cases, more interest will continue to accrue on the loan once it is repaid, even after compounding has occurred. Essentially, this means that the borrower is paying interest on interest.
Deferring loan payments is a method many people use to lower their monthly student loan bills if they are having difficulty making payments. It can certainly be beneficial in the short term, but many lenders recommend making interest-only payments if possible rather than deferring payments entirely. Although the principal amount of the loan will not decrease, it will avoid the capitalization of accrued interest.
This is especially concerning with federal student loans, especially subsidized and unsubsidized loans. In a subsidized loan, the federal government subsidizes or pays the interest that accrues before repayment. On an unsubsidized loan, interest begins to accrue once the loan is issued, and is immediately capitalized into the loan balance when repayment begins. For this reason, some people choose to make interest payments on unsubsidized student loans even while they are still in school.
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