Capitalized interest is not necessarily your financial friend, but it doesn’t have to be your enemy.
The first step to avoiding getting buried underneath capitalized interest is understanding what it is and how it works. After all, your borrowing goal should always be to get the most out of your loan without owing too much more than you initially signed up for.
Here’s what you need to know about capitalized interest.
What Is Capitalized Interest?
Capitalized interest is the amount of interest added to a loan balance. In other words, it is the true cost of borrowing to acquire a long-term asset. When unpaid interest is capitalized, a lender adds interest to an increased balance.
Most commonly, you’ll see capitalized interest attached to student loans. And as anyone with student loans has likely learned, it can affect the repayment significantly.
The reality is that capitalized interest can make your loan balance grow exponentially over time. With capitalized interest, you’re not just borrowing the original loan amount. You’re borrowing money to cover interest costs.
Inevitably, you will be required to pay interest on the interest your lender charged you. Left unattended, loan balances with capital interest can get scarily large, but they don’t have to.
First and foremost, it’s important to understand how capitalized interest can impact your loan repayment.
Repayment of Student Loans
The pace at which your loan balance grows quickens as the amount of interest you borrow keeps increasing. Paying interest atop interest is a type of compounding. However, this form of compounding only adds up in your lender’s favor, never yours.
Here’s a helpful example of how capitalized interest works from The Balance. Let’s say you borrow $20,000 in student loans with an interest rate of 4%. For as long as you’re attending school, interest will accrue on your loan.
Each year, you’ll owe $2,095 in interest plus the original $20,000 by graduation time. Luckily, you’ll have a six-month grace period after you’ve finished school, but you’ll likely want to start saving money right away. In the end, you’ll always owe more than you initially borrowed when capitalized interest is involved.
During this “grace period” where you aren’t required to pay anything on your loan, the interest will be capitalized. In this example, that brings your new balance to $22,095. And here’s where capitalized interest will really come into play. Moving forward, the lender will calculate the interest owed, using the $22,095 as your loan’s principal amount, not the initial $20,000 you borrowed, and the interest amount will continue to increase from there.
Why Timely Repayment Is Important
Some student loans give you the option of holding off on repayment until you’ve completed school completely. While this is definitely a useful feature, it can also increase the cost of your loan in the long run.
In addition, loans may offer the option to skip payments for a period of time. Unsubsidized loans, for instance, will offer forbearance options, but the capitalized interest will be added when the deferment period ends.
If you decide not to repay right away, that’s your right. But the cost of capitalized interest will always build up. With interest charges that go unpaid, your loan balance will only increase. To avoid increasing your loan amount far beyond what you initially borrowed, it’s important to stay on top of repayment when the time comes.
Even if you’re not required to pay anything, it is always best to pay something. So what’s the benefit of paying when you don’t have to? Any money put towards your loan will reduce the amount of capitalized interest tacked on. Check with your lender to learn how much interest you’re charged each month. If nothing else, that is the amount you should pay.
In other words, the sooner you can pay your loan down, the less it will cost you in the long run.
So How Much Will That Loan Really Cost You?
When it comes to loans with capitalized interest, you repay what was given to you and then some. Your total cost will be comprised of the following:
- How much you borrowed: The higher the loan you receive, the higher the interest owed.
- The interest rate: Loans with higher interest rates are more expensive all the way around, so do the math.
- Time: The longer it takes you to pay back what you borrowed, the more interest you’ll be charged along the way.
Unfortunately, interest rates are often far beyond your control. The most control you have over how much you’ll owe comes down to how much you borrowed, and then preventing that amount from increasing via timely repayments.
When you capitalize the interest, monthly payments will always be higher. In turn, keeping your balance as low as possible is important to lighten your debt load over time. No one wants to pay more than they initially borrowed.
The best way to do avoid higher and higher interest rates is to always meet your minimum payment. Otherwise, not only will your debt increase, but your credit will be damaged in the process.
Best Ways to Avoid Capitalized Interest
No matter how financially savvy you might be, capitalized interest can have a costly impact on anyone. That’s why you should do all you can to avoid as much of it as you can. Here are the most helpful tips for minimizing capital interest.
- If you’re still in school, pay interest-only installments. As discussed, making payments monthly against the inevitably accruing interest is always a good way to avoid interest capitalization.
- Don’t take the grace period too literally. While it’s not a requirement, covering the accrued interest during the grace period will prevent interest from being capitalized.
- Lump sums can go a long way. Let’s say you deferred your payments. Consider using lump sums and resources that provide them to pay on the interest. For instance, you could use your tax refund for paying off accrued interest. By doing so, the amount won’t be capitalized when your deferment period ends.
- Keep it standard. To best avoid capitalized interest, financial experts advise sticking to a standard repayment plan. Standard plans protect you from financial mishaps more than the alternatives because your payments will be set up to cover accrued interest and a portion of the principal. In turn, no interest will be capitalized.
How Capitalized Interest Affects Businesses
In business, capitalized interest is the cost of funds used when financing the construction of a long-term asset by a company. Per Investopedia, “this treatment is a requirement under the accrual basis of accounting and increases the amount of the fixed asset on a company’s balance sheet.”
When an organization capitalizes interest, the accrued cost of the long-term asset is then added to what’s known as the “book value.” In turn, it is documented as a “periodic depreciation expense” on the income statement and not considered an interest expense.
Unlike typical expenses, companies are not required to expense loans with capital interest right away. As with student loans, capitalized interest typically comes into play when paying on a long-term asset. And so, companies have the ability to expense these assets in a long-term fashion rather than immediately.
Through this business practice, capitalized interest will show up in installments on the income statement via the “periodic depreciation expense.” As defined by Accounting Tools, the depreciation expense is “the periodic depreciation charge that a business takes against its assets in each reporting period.”
The purpose of this type of charge is to reduce the carrying amount of the company’s fixed assets bit by bit while their inherent value is consumed gradually.
Advantages and Disadvantages of Capitalized Interest
For any company, the advantages and disadvantages all come down to taxes.
When a business capitalizes its interest and applies the cost to long-term assets, they’re able to effectively defer any interest expenses to an accounting period sometime in the future. When it comes to taxes, the company will be able to spot the interest expense as a depreciation expense in a later period when the tax bill is notably higher.
The benefit? It will reduce the overall tax amount the company owes. Of course, there are disadvantages too.
Companies are often required to capitalize their interest on loans needed to construct a long-term asset. And in some ways, their hands will be tied. A company cannot reduce its tax bill in the current period because with capitalized interest, the interest expense will be deferred to a future period. In turn, while there are future advantages, there will be real-time disadvantages and no real benefits in the period in which the loan was taken out.
Unfortunately, businesses can never deduct full interest expenses in the current period. However, the capitalized interest can always be depreciated over time. By capitalizing on the interest expense, companies are able to generate income from the long-term asset and pay it off gradually.
Capitalized interest refers to the cost of borrowing money to obtain or construct a long-term asset. For individuals, that’s most often the cost of their education.
No matter how much you borrow, you should always take advantage of the brief but useful period before interest capitalization, especially if you’re a student. Pay off as much as you can during that grace period!
By staying ahead of capitalized interest, you’ll be able to stay on top of it, reducing the overall cost of your loan.