Lenders make money on loans by charging you interest based on how large a balance you have and how long you take to repay it. The larger your balance and the longer you take to repay it, the more it will cost in interest. Understanding accrued and capitalized interest will help you develop a strategy for repaying your loan at the lowest possible cost.
Accrued Interest
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Accrued interest is the amount of money you owe on your loan based on the interest rate and how much time has passed since your last payment. Calculate accrued interest by dividing your annual interest rate by 365 and multiplying it by your balance and the number of days since your last payment. For example, if your lender charges 9 percent annual interest, your balance is $13,000 and it has been 30 days since your last payment, your accrued interest is 0.09 / 365 x $13,000 x 30, which is $96.16.
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Paying or Delaying Interest
Lenders typically require borrowers to pay accrued interest on a monthly basis. Whenever you send a payment, the lender calculates the accrued interest on the day the payment arrives and applies that amount of your payment to the interest. The remaining part of the payment goes toward reducing the amount of your balance. However, in some situations, lenders allow the borrowers to delay interest payments, in which case, the interest keeps accruing for months or years without being paid.
Capitalized Interest
If a lender adds the accrued interest to the balance that the borrower owes, this is called capitalizing the interest. Future interest charges are then based on this new, higher balance that includes the previously accrued interest. This practice is most commonly carried out by student loan lenders. With many types of student loans, borrowers are allowed to defer payments while they are in school or suffer financial hardship. However, interest still accrues during this time, unless the federal government subsidizes the loan by paying the accrued interest. When the borrower enters the repayment period, the lender capitalizes all unpaid accrued interest and uses this higher balance to calculate monthly payment amounts and future interest charges.
Strategy
If at all possible, you should pay all accrued interest before the lender capitalizes it. Once the interest is capitalized, your monthly cost to carry that debt suddenly increases. You are best off if you pay the interest on a regular basis as it accrues. Another option is to make one or more large payments just before the accrued interest is capitalized to pay off as much of it as possible.
Example
Say you have a student loan for $10,000 that has been accruing interest at a 6.8 percent annual rate for four years while you were in school. The accrued interest after four years is $2,720, or about $1.86 per day. Once the interest is capitalized and your balance is $12,720, interest starts accruing at a rate of about $2.37 per day. On a standard 10-year repayment plan, your monthly payment is $31.30 per month more with the capitalized interest than it would have been if you had paid off the accrued interest before it was capitalized. You will pay a total of $3,756 more over 10 years that you could have avoided by paying the $2,720 of accrued interest before it was capitalized, for a savings of just over $1,000.