Capitalization of arrears occurs when the money that was past due on your mortgage, along with any interest and penalties you have acquired, is just tacked on to the mortgage balance that you owe. For example, assume that you fell behind on your mortgage payments and you owed $10,000 in back payments, plus another $1000 in fees and penalties. The $11,000 that you owed the mortgage company is referred to as "arrears" since that is money that was supposed to be paid that wasn't. If it is capitalized, it is tacked on to your principle balance that you owed on the mortgage. So, if you had $100,000 remaining on the mortgage, you will now have $111,000. Going forward, your mortgage payments will be calculated based on you owing $111,000 and interest will also be charged on that $111,000 principle as opposed to on the $100,000 that you owed before.
Capitalization of arrears is generally the most common type of settlement that your mortgage company will offer you if you are trying to get current on a mortgage that you have fallen behind on. This is the best option for the lender because then they really are not actually losing out on anything or giving you anything off of your loan. They are just giving you a clean slate and setting the clock back to "current" but you will end up paying back the full amount you owed.
If you are considering a mortgage settlement, you should consult with a lawyer before making any final decisions. A lawyer can explain to you exactly what impact the settlement will have on your finances and can help you to decide if that settlement is the right option for you or not.