Interest accrual, capitalization, and compounding are three distinct processes affecting student loans. Let’s briefly clarify each process with examples.
Accrued interest is the daily accumulation of interest on a loan’s principal balance using simple interest. It’s charged only on the principal, not any previously accrued interest.
Example: With a $10,000 loan at a 6% annual interest rate, the daily interest accrual is ($10,000 × 0.06) / 365 ≈ $1.64. After 30 days, accrued interest is $1.64 × 30 = $49.20.
Capitalization occurs when unpaid accrued interest is added to the principal balance, increasing the amount on which future interest is calculated.
Example: If the $49.20 accrued interest is capitalized, the new principal balance becomes $10,049.20, and future interest is calculated on this new balance.
Some student loans compound interest monthly or yearly, calculating interest on the initial principal and any previously accrued interest.
Example: With a $10,000 loan at a 6% annual interest rate compounding yearly, the first year’s interest is $10,000 × 0.06 = $600. The next year, interest is calculated on the new balance ($10,600 × 0.06) = $636, showing how compound interest grows the loan balance faster than simple interest.