Capitalization of interest occurs when a lender allows the borrower to postpone making interest payments on a loan. The interest that accrues during that time is then added in to the balance of the loan. Capitalization of interest typically occurs with student loans, as well as construction or real estate loans. The lender will inform the borrower ahead of time how the interest process will work; in some cases, it will be necessary to apply for a deferment on a loan to postpone interest payments.
In construction, this interest is viewed as an asset, as the final loan should include all the costs that were incurred to construct the property. This occurs because a loan is generally issued for construction purposes well before repayment begins or the construction is completed, so the interest may be deferred and capitalized into the final loan. Typically, capitalization of interest will not occur until the borrower starts repayment on the loan. Interest will accrue on the loan even if it is not yet in repayment, but the borrower is often free to make an interest-only payment to prevent capitalization of interest from occurring. Though this process can be seen as a convenient way to avoid making payments on a loan for a period of time, it has downsides as well.
Capitalization of interest increases the final amount due on the loan, increasing as well 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 in repayment, even after the capitalization has occurred. Essentially, this means that the borrower is paying interest on interest.
Deferring payments on loans is a method that many people use to decrease 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 altogether. Though the principal amount of the loan will not decrease, it will prevent capitalization of accrued interest from occurring.
This is especially a concern with federal student loans, notably subsidized and unsubsidized loans. In a subsidized loan, interest that accrues before repayment is subsidized, or paid, by the federal government. In an unsubsidized loan, interest starts to accrue once the loan is issued, and is immediately capitalized into the balance of the loan when repayment begins. For this reason, some people choose to make interest payments on unsubsidized student loans even while they are still in school.