What is the difference between capitalized interest and interest paid in arrears?

• A. Capitalized interest is paid monthly; interest in arrears is added to loan.
• B. Capitalized interest is charged upfront; interest in arrears accrues during loan.
• C. Capitalized interest reduces balance; interest in arrears increases balance.
• D. Capitalized interest is added to the loan balance; interest paid in arrears is paid monthly.

Answer: (D)

The key idea is how interest is treated: whether it stays as a separate cost or becomes part of what you owe.

If interest is capitalized, it’s added to the loan’s principal. That means the outstanding balance grows, and future interest accrues on that larger amount. This is common when payments don’t cover all the interest or in programs that allow negative amortization.

If interest is paid in arrears, the interest for the period is paid after that period ends. The payment settles the accrued interest and does not increase the loan balance. The loan balance changes mainly due to principal repayments (and any capitalization), not because the interest is paid.

So the correct distinction is: capitalized interest is added to the loan balance, while interest paid in arrears is paid each period (typically monthly) and does not capitalize into the balance.