What Is Capitalized Interest?

Two common ways people come across capitalized interest are with student loans and negative amortization mortgage loans.

Student loans: As soon as you get the borrowed money to pay for education expenses, it begins accruing interest. But loan repayment doesn’t typically begin until after graduation – making prime ground for capitalized interest. In fact, many times there is even a 6- to 9-month grace period after graduation that allows you to further delay starting to make payments. Grace periods, deferments, and forbearances are all situations that can incur capitalized interest.

Negative amortization loans: In a negative amortization loan, the payments are too small to cover the normal interest charges and principal payments that would be required to pay off the loan over time. For example, if you have a negative amortizing mortgage, as time goes by and even though you make payments, your loan balance keeps increasing because the unpaid interest charges are capitalized each month. Negative amortization mortgages can be especially risky if they increase above the value of the underlying home. These loans are not common and, in fact, may even be classified as predatory because of the impact of recurring capitalized interest.¹

Some of the same student loan features that add financial flexibility for students/parents can end up costing extra money in the end, because of capitalized interest. Deferments – the ability to pause loan payments for up to three years to accommodate things like in-school enrollment, unemployment, military deployment, and financial hardship – can be helpful in the short term, but the deferred interest that builds up during the deferment period can sometimes be capitalized and added to the loan balance.

Similarly, a general forbearance, which pauses loan payments for up to a year if you’re having financial difficulties, almost always results in capitalized interest. Forbearance should not be confused with “forgiveness.”

Federal loans can be subsidized or unsubsidized; one of the main differences is the government pays the capitalized interest in a subsidized loan and you pay it in an unsubsidized loan. Additionally, private loans can differ in their treatment of capitalized interest.

Typically, interest accrues on student loans during the duration of the loan and even during the grace period. When this happens, interest is calculated and added to the balance, meaning that it can add up quickly over time. For this reason, it’s a good idea to make payments on your student loan during the grace period, or at least pay enough to cover the monthly interest that accrues. Keep in mind that federal student loans may accrue interest differently.²

There are several online calculators that can help you understand the amount of capitalized interest and additional costs you would incur by pausing payments for your student loan.

You may be able to avoid paying capitalized interest on your loan in one of two ways:

Pay off the accrued interest before it capitalizes
By knowing the date on which that capitalized interest will be added to your principal balance, you can take steps to avoid these additional costs. By paying interest off before that date, you can prevent interest from capitalizing.³

Make interest-only payments
Another option is to make interest-only payments on your student loan during any period that your loan is accruing interest, like when you are in school. If this is feasible, you will need to contact your lender to make special arrangements for interest-only payments.⁴