Capitalization is the addition of unpaid accrued interest to the principal balance of a Direct Loan.
How it works
Interest accrues daily on the outstanding principal. If the borrower does not pay that interest, it accumulates in a separate bucket. At a capitalization event the servicer adds the accrued interest to the principal and notifies the borrower. The new, higher principal is then used to calculate future interest and payments.
Example: a borrower has a $10,000 unsubsidized loan and allows $800 of interest to accrue during a forbearance. At the end of the forbearance the $800 is capitalized. The new principal is $10,800, and subsequent interest is calculated on that higher amount.
How it differs
Accrual is the daily addition of interest that has not yet been capitalized. Compounding describes the effect after capitalization, when new interest is charged on previously capitalized interest. A payment applied to interest prevents capitalization of that amount.
Common errors
Assuming interest only capitalizes once. Believing that income-driven repayment plans never capitalize interest. Ignoring capitalization when estimating the long-term cost of repeated forbearances.
References
- 1. Federal Student Aid interest capitalizationWhen unpaid interest is added to principal
- 2. 34 CFR 685.202 chargesRegulatory treatment
Capitalization is the addition of unpaid accrued interest to the principal balance of a Direct Loan.