Interest and Capitalization

Interest is the price you pay to borrow money. When a lender provides a loan, they make a profit off of the interest paid on top of the original loan amount.

Interest rates affect the true amount you pay for homes, cars and other purchases made with credit. How an interest rate is determined depends on the type of loan.

Interest effects the overall price you pay after your loan is completely paid off. For example, if you borrow $100 with a 5% interest rate, you will pay $105 dollars back to the lender you borrowed from. The lender will make $5 in profit.

There are several types of interest you may encounter throughout your life. Every loan has its own interest rate that will determine the true amount you owe.  Before you borrow, make sure you understand exactly how an interest rate will affect how much you owe at the end of the day.

What is Considered a High Interest Rate?

Every loan type has its own average amount of interest. The rate is calculated based on a number of factors, including:

  • The principal amount
  • The length of the loan term
  • The repayment schedule
  • Monthly payment amount
  • Market factors
  • The borrower’s credit-worthiness

Because no two loans are alike, it can be hard to determine what a good interest rate is. Your credit cards, auto loans, personal loans and mortgages all have unique factors that are used to determine your interest rate.

What is an APR?

An Annual Performance Rate, or APR, is another rate you may encounter when taking out a personal loan, mortgage loan, auto loan or credit card. This rate is the amount of interest you will pay over the course of a year, including any extra fees your loan process may incur.

The APR will typically be .1 to .5% higher than the interest rate. If the APR is higher, expect to have more fees.

Many borrowers compare APRs when deciding between different loan options. These rates are valuable negotiating tools – it is not uncommon to reference the rate of a competing lender in order to secure the best rate available.

Interest Rate Calculator:

Capitalization is the addition of unpaid interest to the principal balance of a loan. Generally, during periods when you are making payments on your federal student loans, your monthly loan payment will cover all of the interest that accrues (accumulates) between monthly payments, and you won’t have any unpaid interest. However, unpaid interest can accrue under certain circumstances. For example, you are not required to make monthly payments during a period of deferment, but if you have an unsubsidized loan, interest continues to accrue during the deferment period, and you are responsible for paying the interest. Unpaid interest may also accrue if you are repaying your loans under an income-driven repayment plan, and your required monthly loan payment is less than the amount of interest that accrues between payments.

When the interest on your federal student loan is not paid as it accrues during periods when you are responsible for paying the interest, your lender may capitalize the unpaid interest. This increases the outstanding principal amount due on the loan. Interest is then charged on that higher principal balance, increasing the overall cost of the loan. Depending on your repayment plan, capitalization may also cause your monthly payment amount to increase.

There are several situations in which interest capitalizes.

For federal student loans, capitalization of unpaid interest occurs:

  • When the grace period ends on an unsubsidized loan.
  • After a period of forbearance.
  • After a period of deferment, for unsubsidized loans.
  • If you leave the Revised Pay as You Earn (REPAYE), Pay as You Earn (PAYE) or Income-Based-Repayment (IBR) plan.
  • If you don’t recertify your income annually for the REPAYE, PAYE and IBR plans.
  • If you no longer qualify to make payments based on your income under PAYE or IBR.
  • If you’re on the Income-Contingent Repayment (ICR) plan, it capitalizes annually.
  • When you consolidate federal loans.

For private student loans, interest capitalization typically happens in the situations below, but check with your lender to confirm.

  • At the end of the grace period.
  • After a period of deferment.
  • After a period of forbearance.