Definition
Capitalized interest is an accounting practice where the interest expenses are added to the cost of a long-term asset, instead of being recognized as an immediate expense. It is usually applicable when the interest is incurred during the production, construction, or acquisition of a long-term asset. Once the asset is put into service, the capitalized interest is gradually expensed through depreciation.
Key Takeaways
- Capitalized Interest is the cost of borrowing that is added to the principal amount of a loan or mortgage, rather than being paid off immediately. This effectively increases the total amount of debt, as the borrower needs to pay interest on the initial capital plus the accumulated interest.
- While capitalization can lower initial payments, it can lead to a higher total repayment over the long run because the borrower is paying interest on a larger amount. This often occurs with student loans, mortgages, and other types of installment debt when payments are deferred or interest-only.
- Understanding how Capitalized Interest works is essential for borrowers to accurately calculate their long-term costs and make informed decisions about loans and repayment strategies. It can also impact the accounting and taxation of companies, who may capitalize interest on construction or fixed assets.
Importance
Capitalized interest is a crucial financial term as it refers to the process of adding any unpaid interest to the principal amount of a loan or debt, effectively increasing the total amount owed. It plays a significant role in various financial activities, such as in investments, loans, or bonds.
From a borrower’s perspective, understanding capitalized interest is essential as it can significantly impact the total cost of borrowing. Not making interest payments during periods of deferment or grace periods, for example in student loans, potentially leads to a higher principal amount via interest capitalization, consequently leading to higher overall debt.
On the other hand, for lenders or investors, capitalized interest can enhance the earning potential from an investment or loan by accumulating more through the re-investment of earnings. Therefore, comprehension of capitalized interest is important for sound financial decision-making and planning.
Explanation
Capitalized interest is an essential aspect of finance which is primarily used in long-term financing situations such as construction loans or certain types of student loans. It is essentially the interest that is accrued over a certain period, however, instead of demanding immediate payment, it is added to the original sum of the loan or principal.
This method serves to alleviate the immediate financial burden on the borrower while the project or education is in progress and not yet producing income to meet interest payments. The purpose of capitalized interest is to provide financial convenience and assistance to the debtor during periods where repayment might not be possible or viable.
In the case of a construction project, for example, the property isn’t generating income during the building phase, making it challenging for the borrower to make regular interest payments. Similarly, for student loans, while the student is still in education and likely not earning a substantial income, capitalized interest allows the cost to be deferred until they’ve graduated and started earning.
However, it’s important to note that in the long run, this will increase the total cost of the loan as interest will be charged on the increased principal amount.
Examples of Capitalized Interest
Student Loans: When a student opts for higher education and applies for a loan, the lender usually allows them to defer their interest payments until they finish school and start earning. This is a grace period when students do not need to pay anything towards their loan. However, during this period, the interest keeps accumulating and is added to the original loan amount. This is known as capitalized interest. The student will eventually pay back a larger amount than initially borrowed.
Construction Loans: When a company builds a new property, the interest on the borrowed funds used for construction is often capitalized. This means the interest is added to the cost of the property on the company’s balance sheet, rather than being recognized as an expense immediately. This can improve the company’s current earnings, but it also means the company will pay more interest over time, because the principal loan balance has increased.
Corporate Bonds: If a company issues a bond and chooses not to pay the interest immediately, the interest gets capitalized. This means the interest is added to the principal amount of the bond, and future interest is calculated on this increased amount. This gives the company some financial relief in the short term but increases its long-term obligations.
Frequently Asked Questions about Capitalized Interest
What is Capitalized Interest?
Capitalized interest is the cost of borrowing that is added to the principal balance of a loan. When interest is capitalized, the interest charges that have been accrued to date are added to the principal, and future interest charges are based on this larger principal amount.
How is Capitalized Interest Calculated?
Interest is capitalized by adding unpaid interest charges to the principal of the loan, increasing the total amount of the loan. The new total is then used to calculate future interest charges. This means that the borrower will be paying interest on the original principal plus any interest that has been capitalized.
What is an example of Capitalized Interest?
Suppose a student obtains a $10,000 loan to pay for college expenses. If the student doesn’t pay the interest while attending school, the interest may be capitalized. For instance, if $1,500 in interest charges accrues over time and is added to the loan, the new principal loan balance upon graduation would be $11,500, and future interest would be calculated on this amount.
How does Capitalized Interest affect my loan?
When interest is capitalized, it increases the principal balance of your loan, meaning you’ll have to pay interest on a larger total loan amount. This will increase the total amount you have to repay. By paying the accrued interest before it is capitalized, you can save money over the life of your loan.
Related Entrepreneurship Terms
- Accrual Accounting
- Amortization Schedule
- Deferred Interest
- Capitalization Period
- Debt Financing
Sources for More Information
- Investopedia – It is a comprehensive website with detailed explainers on finance and investing topics like capitalized interest.
- Corporate Finance Institute (CFI) – This site offers professional finance training and resources. Capitalized interest is likely discussed in the context of various finance and accounting courses.
- Khan Academy – A trusted educational site with resources on a wide range of topics, including finance and economics.
- AccountingCoach – This site provides free and comprehensive educational resources on accounting topics, including capitalized interest.
