Capitalized interest is interest that you add to a loan balance, and you often see it with student loans and accounting practices.
With student loans, you can take interest costs instead of paying the interest as it comes as a result of taking advantage. Because the interest charges go unpaid, the costs are added to your loan balance. As a result, the loan balance increases over time and you end up with a larger loan amount upon graduation. At some point you have to pay that interest. This happens in the form of higher monthly payments or payments that take longer than they would otherwise have taken.
In accounting, capitalized interest is the total cost of interest to a project. Instead of loading the interest charges each year, the interest charges are treated as part of the cost basis of a long-term asset and amortized over time.
With some loans, such as student loans, you may have to temporarily skip payments on your loan.
For example, unsubsidized Stafford loans allow you to postpone payments until you finish school. That is an attractive feature because it helps with your cash flow this month, but it can lead to higher costs and tighter cash flow in the future.
Whether you make payments, interest is still accruing (or being charged against your loan balance). You have borrowed money so that the interest charges follow naturally. If you choose not to pay anything, your total equity loan when you are ready the school will be higher than the amount you actually received and spent.
Note that with subsidized loans, the federal government pays the interest costs so that your loan interest does not get capitalized.
Capitalized interest makes your loan balance grow. As a result, you are not only borrowing what you originally borrowed for school and living expenses, you are also borrowing to cover interest costs. Because of that, you also have to pay interest on the interest your banker charged you.
Reverse compounding: Your loan balance will increase faster and faster if the amount of interest that you “borrow” continues to increase. Paying out the interest on top of interest is a form of compounding, but it doesn’t work to the advantage, not yours is your lender. Another term for this, which was a favorite loan feature before the mortgage crisis, is negative write-off.
Every payment helps: Even if you are not obliged to pay anything, it is best to pay something. For example during forbearance or suspension, you would not have to make a full payment. But everything you put toward the loan will reduce the amount of interest that you capitalize. Your banker will provide you with information about how much interest is charged to your account every month. Pay at least as much so you don’t get deeper into debt. This puts you in a better position for the inevitable day when you have to start making larger “write off” monthly payments that pay off your debt.
As a student, you don’t care if your loan balance increases every month. But a larger loan balance will affect you in the coming years – possibly for many years to come. It also means that you have more interest over the term of your loan.
The “cost” of a loan, ignoring a one-off cost, is the interest you pay. In other words, you pay back what they gave you, and you pay a little extra. Your total costs are driven by:
Especially with federal student loans, you would not have much control over the interest. But you can control the amount that you borrow, and you can prevent that amount from growing on you. But if you capitalize interest, your monthly payments (and lifelong interest charges) will be higher. How much higher? FinAid has a handy calculator for running the numbers on hold.
If you want to see how things work for yourself, you can also use a spreadsheet (Excel or Google Sheets, for example) to model your own loan. Simply set the payments to zero for a sample waiting period.
Remember that your minimum payment requirement is just that – the minimum required to prevent damage to your credit and late payment costs. You can always pay more, and it is often wise to do that. Paying extra on your debt helps you spend less on interest, eliminate debt faster, and qualify for larger loans with better conditions in the future.
What’s more, skipping payments can ultimately cost you in other ways. If you hope for Public Student Loan Forgiveness (PSLF), you may be able to make discounted payments in low-earning years, even if you are not required to make a payment. This helps you chip away with the desired payments and spend less overall on your student loans.