Capitalization, in a financing context, refers to the practice of adding unpaid interest to the principal balance of the loan, thereby increasing the total amount owed.
This results in future interest being calculated on the new, higher principal, compounding the borrower's debt.
Borrowers capitalize interest for many reasons—for example:
- As part of a strategy (like the Smith Manoeuvre, where borrowers use the HELOC to pay the monthly interest due)
- For short-term cash flow relief
- As part of a fixed-payment variable mortgage
- When taking advantage of a lender's skip-a-payment feature
- As part of a lender's default management plan