What Is Capitalization Interest?

The capitalization of interest is the cost of interest added to an asset or loan. For example, the student loan industry commonly applies the capitalization of interest to student loans. The capitalization of interest differs from the simple interest you might associate with the repayment of loan obligations. How much extra the capitalization of interest will cost you over the life of your loan depends on the specific type of loan and the terms of your loan’s contract.

Subsidized Versus Unsubsidized

If you have a subsidized student loan, the terms of the loan typically do not require you to pay any interest while you are in school, generally as a full-time student. In most cases, however, the interest will begin to capitalize once you are out of school and enter the workforce. If your loan is unsubsidized, your loan will begin to accrue interest while you are in school even if you can defer payments during this time. The capitalization of interest begins as soon as your loan terms no longer allow deferment of interest on your loan.

Explaining Capitalization

The capitalization of interest means that your loan will accrue interest. Each month or payment period, your loan will factor the accrued interest charge into the total amount owed on the loan. This means the next payment will include interest on the new total that may includes previous interest. In the case of a student loan, if you choose to accrue interest while continuing to study by deferring payments until after graduation, the capitalization of interest may significantly increase the balance owed once you start to make loan payments.

Dealing with Capitalized Interest

Because of this increase in total amount owed, some students choose to make interest payments while continuing their studies rather than defer the payments entirely. Deferment is the process that allows you to postpone paying interest and principal payments until after you finish school and start to work. Most student loans offer this option to allow students to continue studying without having to make student loan payments. Choosing to pay the interest as it accrues while in school, however, can save you a significant amount of money in the long term, depending on the amount of your loan.

Other Capitalization Contexts

Although most commonly applied to student loans, the capitalization of interest is not limited to this type of loan. Interest capitalization can apply to any situation that involves the repayment of a debt. For example, business loans or financing for any purpose from a financial institution or a private lender can result in the capitalization of interest. A business should always record capitalized interest payments on its income statements in the same period the business makes the capitalized interest payment.

References

• AccountingCoach: What is Capitalized Interest?; Harold Averkamp
• Student Loans for College: What is Capitalized Interest on Student Loans?
• "Principles of Finance"; Scott Besley and Eugene Brigham; 2008