Capitalized interest is a process where lenders defer interest payments on loans made to individuals and businesses. This is beneficial as borrowers can avoid spending money to repay the loan if they are not making money from the invested funds. Cons are also present with capitalized interest as the principle balance typically increases for the borrower, making future payments higher. When businesses borrow funds and engage in a loan with interest capitalization, the loan must meet specific requirements. These requirements allow the company to account for the loan in a certain way, according to national or global accounting standards.
The three requirements for loans with capitalized interest include: interest incurred on the loan, business activities that ensure the asset is going to meet an intended use, and specific expenditures made for the asset in question. When a company’s loan meets these three requirements, it can account for the interest by capitalizing it rather than expensing it. Capitalization in these terms means adding the interest amount to the asset value listed in the loan paperwork. The benefit is that the interest will add to the company’s economic wealth, especially once the company pays back the loan and the debt is off the company’s accounting books.
For individuals, capitalized interest is common on educational loans. Students are not required to repay the loans until they graduate or stop attending school for other reasons. The lender servicing the educational loan will often send statements indicating the capitalized interest amounts for the loan. The interest will require repayment along with any future interest on the loan.
Cons to capitalized interest are often more negative for individuals rather than businesses. For example, educational loans will continue to accrue interest as long as the borrower remains in college. Extending the number of years to complete the degree will result in higher amounts of interest capitalized — added to the principle balance — of the loan. This will significantly increase the principle balance, thereby increasing the future interest payments for the loans. One the student starts repayment, the payments typically go against current interest and then capitalized interest. The original principle balance will not reduce until the capitalized interest portion is fully repaid. Businesses do not typically face this problem because they often have more money to repay the loan more quickly than individuals.