What are Interest Capitalization and compounding frequency?

When borrowers unable to pay interest on time, it will add to principal amount of the borrower’s loan account at regular frequency. In the other words Capitalization frequency is the addition of unpaid interest to the principal balance of your loan. That means it is added to borrower’s Current Principal and interest will now be calculated on this new amount. That’s capitalized interest.

Example of capitalization: Suppose a bank charges monthly interest of Rs.1500/ on a loan amount of Rupees One lakh. If the borrower is unable to pay the interest debited to the loan account, unpaid interest of Rs.1500/- is capitalized. Further interest will now be calculated on this new amount of Rs.101500/-

Compounding frequency is the time periods when interest will be calculated on top of the original loan amount. To determine the period interest rate, we simply take the annual rate of interest, and divide it by the number of compounding frequencies in a year. For example: if 12% interest is compounded quarterly (4 times a year), then the period interest rate is 3% (12% ÷4) or if interest is compounded monthly then the interest rate is 1% (i.e.12÷12)

Conclusion: Capitalized interest is unpaid, accrued interest that is added to the principal balance of a loan. It is also called ‘compound interest or interest on interest’.  The capitalized interest increases the total debt of the borrower. Deferred education loans are a good example of capitalized interest. Compounding frequency is the number of compounding periods in a year. The rate at which compound interest accrues depends on the frequency of compounding such that the higher the number of compounding the greater the compound interest.