What does interest capitalization refer to?

Interest capitalization refers to the process where accrued interest is added to the principal balance of a loan. This typically occurs in specific situations, such as during a period of deferment or for certain types of loans, such as student loans. When interest is capitalized, it increases the total amount owed since the borrower will subsequently pay interest on that larger principal balance. This can impact the total cost of the loan over time, as future interest calculations will be based on the heightened principal.

This concept is crucial in understanding how loans grow over time, especially for those who may not make interest payments during a deferment period—such as while in school or during financial hardship. As a result of capitalization, borrowers may find themselves with a larger debt than initially anticipated when repayment begins.