How does interest capitalization affect the total amount owed on a loan?

• A. It eliminates the need to pay interest in future periods.
• B. It has no effect on the total amount owed; only the payment schedule changes.
• C. It increases the total amount owed because unpaid interest is added to the principal balance.
• D. It decreases the total amount owed by reducing the interest rate.

Answer: (C)

Verified step by step guidance

1. Understand the concept of interest capitalization: Interest capitalization occurs when unpaid interest is added to the principal balance of a loan. This means that the loan's principal increases, and future interest calculations are based on this higher principal amount.
2. Analyze the impact of capitalization on the total amount owed: Since the unpaid interest becomes part of the principal, the borrower will owe interest on the increased principal balance in future periods. This results in a higher total amount owed over the life of the loan.
3. Compare interest capitalization with other scenarios: Unlike scenarios where interest is paid regularly, capitalization increases the principal balance, which leads to compounding interest. This is different from simply adjusting the payment schedule or reducing the interest rate.
4. Clarify why the other options are incorrect: For example, interest capitalization does not eliminate the need to pay interest in future periods; it actually increases the amount of interest owed. Similarly, it does not decrease the total amount owed or reduce the interest rate.
5. Summarize the correct answer: Interest capitalization increases the total amount owed because unpaid interest is added to the principal balance, leading to compounding interest on the higher principal.