interest capitalization
The addition of unpaid interest to the principal balance of a loan — increasing the amount owed and future interest charges.
Example
“Interest capitalization on deferred student loans added $4,200 to the principal balance.”
Memory Tip
CAPITALIZATION — unpaid interest becomes principal. Then you pay interest on the interest.
Why It Matters
Interest capitalization directly affects how much you will ultimately pay back on a loan. When interest is capitalized, you end up paying interest on interest, which accelerates debt growth and can significantly increase your total cost of borrowing over time.
Common Misconception
Many people think that if they do not pay interest when it is due, it simply disappears or gets forgiven. In reality, unpaid interest gets added to the principal, making the debt larger and creating a compounding effect that makes the loan much more expensive.
In Practice
Consider a student loan with a 5 percent interest rate and a 25,000 dollar principal balance. If 1,250 dollars in annual interest goes unpaid for three years, that 3,750 dollars gets added to the principal, making the new balance 28,750 dollars and increasing all future interest calculations based on this larger amount.
Etymology
From Latin 'capitalis' meaning of the head — adding interest to the head of the loan.
Common Misspellings
Compare debt consolidation options
Related Terms
More in debt
Other debt terms you should know
See Also
Need financial definitions?
Clear definitions for 2,500+ finance, insurance, and investing terms.