What does it mean to capitalize on interest on a loan?
Capitalized interest is the interest you add to your loan balance, and you often see that with student loans and accounting practices.
Capitalize on interest costs instead of paying interest
With student loans, you can capitalize on interest costs instead of paying interest at the time of arrival. Since no interest is payable, fees are added to your loan. As a result, the loan balance increases over time and ends with a higher loan amount at graduation.
At some point, you will have to pay these interest rates. This happens in the form of higher monthly payments or payments that take longer than would otherwise be the case.
In accounting, capitalized interest is the total cost of interest in a project. Instead of collecting interest expenses annually, interest expenses are treated as part of long-term assets and amortized costs over time.
Capitalization of student loan interest
With some loans, such as student loans, you may be able to temporarily skip payments on your loan.
Stafford non-refundable loans, for example, allow you to defer payments until you graduate. It’s an attractive feature because it helps you with your cash flow this month, but it can lead to higher costs and tighter cash flow in the future.
Whether you pay it or not, interest is still accumulating (or charged on your loan).
You have borrowed money, so interest fees naturally follow. If you decide not to pay anything, the total loan amount when you finish school will be greater than the amount of money you received and spent.
Keep in mind that with subsidized loans, the federal government pays those interest costs, so your interest rate does not capitalize.
Increase in condition
Capitalized interest accounts for the growth of the loan balance. As a result, you not only borrow what you originally borrowed for your school and living expenses, but you also borrow to cover the cost of interest. Because of this, you also have to pay interest on the interest you have been charged.
Reverse change: Your loan balance will increase faster and faster as the amount of interest you borrow continues to increase. Paying interest is a form of compounding, but it works for the benefit of your lender – not yours.
Another term for this, which was a favorite loan before the mortgage crisis, is negative amortization.
Any payments help: Even if you are not required to pay anything, it is best to pay for something. For example, during vacations or delays, you may not need to make a full payment.
But anything you put on credit will reduce the interest you use. Your lender can provide information on how much interest is charged to your account each month.
Pay at least that much so you don’t go deeper into debt. Doing so puts you in a better position on the inevitable day when you have to start making bigger “amortized” monthly payments that pay off your debt.
As a student, you may not care if your credit balance goes up every month. But a higher credit balance will affect you in the years to come – probably in the coming years. It also means that you will pay more interest over the life of your loan.
The “cost” of a loan, ignoring the one-time fees, is the interest you pay. In other words, you repay what they gave you, and pay a little more. The total costs are:
- The amount you borrowed: The higher your credit balance, the more interest you will pay.
- Interest rate: The higher the rate, the more expensive it is to borrow
- How much time you take to repay: If it lasts longer, there are more periods (months and years) during which your lender charges interest.
Especially with federal student loans, you may not have much control over the interest rate.
But you can control the amount you lend, and you can prevent that amount from growing on you. But if you capitalize on interest, your monthly payments (and lifetime interest costs) will be higher. How much bigger is it? FinAid has a useful calculator for keeping numbers on hold.
If you want to see how things work for themselves, you can also use spreadsheets (such as Excel or Google Sheets, for example) to create your own credit. Just set the payments to zero for the sample disposal period.
Why not pay extra?
Remember that the minimum required payment is just that – the minimum required to prevent damage to credit and postpay payments. You can always pay more and it is often wise to do so.
Paying extra on your debt helps you spend less on interest, eliminate debt faster, and qualify for bigger loans with better conditions in the future.