To add unpaid accrued interest to unpaid principal. This increases your total outstanding principal. Thus, if you choose a lender that capitalizes once a year or more, you may be paying interest on interest.
Capitalizing interest means that all interest accrued is added to the principal amount of your loan. Additional interest would then be based upon the higher principal amount. In other words, you would be paying interest on interest. If you are borrowing a Federal Stafford Loan that is unsubsidized, you will be able to indicate on your master promissory note (MPN) whether you choose to pay your interest quarterly or have the interest capitalize while you are in school. Choosing to pay your interest quarterly will minimize your loan debt.