How does interest capitalization affect loan balances?

Interest capitalization significantly impacts loan balances by adding unpaid interest to the principal amount, which increases the total debt owed. When interest capitalizes, it means that any interest that has not been paid is added to the outstanding balance of the loan. This can occur in various types of loans, including student loans and mortgages, typically after certain periods of deferment or forbearance.

For example, if a borrower has accrued interest on a loan but has not made any payments during a specified time, that interest is added to the principal balance. Subsequently, the new principal balance now reflects the accumulated interest, leading to a larger total amount that must be repaid. As a result, the borrower ends up paying interest on a higher balance, increasing the overall cost of the loan over time.

This process can lead to a cycle of growing debt if not managed properly, making it crucial for borrowers to understand how interest capitalization can affect their financial situation.