Demystifying Capitalized Interest
What You Need to Know

What Is Capitalized Interest?

Capitalized interest is the interest cost that a company adds to the cost of a long-term asset, like a building or equipment, instead of listing it as an expense right away.
When a company borrows money to buy or build something that will last a long time, like a factory or big machine, the interest they pay on that loan isn't just counted as a regular expense.
Instead, the interest is added to the overall cost of that long-term asset on the company's balance sheet.
Over time, this interest cost is slowly shown on the company's income statement as depreciation. This means a little bit of the interest cost is counted as an expense each year, over the asset's useful life.
In simple terms, capitalized interest spreads out the cost of borrowing money over many years, making it part of the asset's value rather than an immediate expense.

Example of Capitalized Interest

Imagine you have a $30,000 student loan with an interest rate of 6.05% and you plan to pay it back over 10 years. Let's say you don't make any payments while you're in school or during the grace period after you graduate.

Here’s what happens:

One-Time Capitalization: If the interest is added to your loan balance once when you start paying it back, you'll end up with an extra $4,688.75 added to your loan. This is because the interest has been growing while you were in school and during the grace period.

Monthly Capitalization: If the interest is added to your loan balance every month while you're in school and during the grace period, you'll end up with an extra $5,142.88 added to your loan.

Paying Interest as It Builds Up: If you pay the interest while you’re in school and during the grace period, you won’t have any extra interest added to your loan balance.

Here's what this means for you:

If the interest is added once when you start paying back, your loan will cost $1,571.96 more than if you paid the interest as it builds up.
If the interest is added every month, your loan will cost $2,178.33 more than if you paid the interest as it builds up. This is $606.38 more than the one-time addition.
In short, if you pay the interest while you're in school and during the grace period, you’ll save the most money. Letting the interest add up makes the loan more expensive in the long run.

How to Avoid Capitalized Interest

Capitalized interest means paying interest on interest, which can make your loan more expensive. Here's how you can avoid it:

1. Understand How Payments Are Applied: For most federal student loans, payments first cover fees, then collection charges, then interest, and finally the principal (the amount you originally borrowed).

2. Pay Interest Before It Capitalizes: To avoid capitalized interest, try to pay off at least the interest that accrues.

• At the End of Grace Periods: For unsubsidized federal loans, pay off the interest in a lump sum before it gets added to your loan balance at the end of the grace period or other deferment periods.
• During School and Grace Periods: Pay the interest on unsubsidized federal loans and private loans as it accrues while you're in school and during the grace period.
• During Forbearance Periods: Pay the interest on all federal loans at the end of forbearance periods or as it accrues. For private student loans and parent loans, pay the interest during forbearance. This is known as partial forbearance.
• Income-Driven Repayment Plans: If you're on a repayment plan where your payments don’t cover all the interest (negatively amortized plans), try to at least pay the interest that builds up.
• Look for Special Programs: Some lenders offer programs where you can get a lower interest rate on private student loans if you agree to make small fixed monthly payments (like $25 per month per loan) or pay the interest that accrues during school and grace periods.

Why This Matters:
When you start repaying your student loans, you want to make sure your payments are reducing the amount you borrowed. However, if your loans have capitalized interest, it can take a few years before your payments start to lower the principal balance. By paying the interest as it accrues, you can avoid the extra cost and start paying down the principal sooner.

Capitalized Interest vs Expensed Interest

Let's break down the difference between capitalized interest and expensed interest in a way that's easy to understand.

So, from the perspective of how companies keep track of their money (something called accrual accounting), capitalizing interest is like tying the costs of using a long-term asset to the money that asset makes over time. But here's the thing: companies only bother capitalizing interest if it's a big enough deal to actually affect their financial statements. Otherwise, they just expense it right away.

Now, when a company does decide to capitalize interest, it doesn't really do much to their income statement right away. Instead, it kinda hangs out in the background and only starts showing up as an expense in later periods through something called depreciation. Basically, it's like spreading out the cost of that interest over time.

When a company books capitalized interest, it's basically saying, "Hey, we're gonna pay this interest eventually, so let's put it on our books as part of the cost of the asset." The actual entry looks like this: we debit the asset account (because we're adding to what it's worth) and credit cash (assuming we paid the interest) or credit an open liability account if the interest hasn't been paid yet.

But here's the kicker: whether a company capitalizes or expenses interest in the long run, it's gonna have the same impact on their financial statements. And when it comes to short-term cash stuff, like if they have to pay interest right away, it's gonna be the same either way. The only real difference is when that expense shows up on the income statement.

So yeah, that's the deal with capitalized interest versus expensed interest. It's all about timing and how companies keep track of their money.

Capitalized Interest vs Accrued Interest

Let's talk about two kinds of interest: accrued interest and capitalized interest. They're not exactly the same, but they can sometimes overlap.

First up, accrued interest. This is just the interest that piles up on a loan between payments. So, if you miss a payment on your loan, the interest keeps growing until you catch up with your payments. That growing interest is what we call accrued interest.

Now, sometimes accrued interest and capitalized interest can be kinda like two peas in a pod. Like, if you miss a payment and that unpaid interest gets added to your loan balance, then the accrued interest becomes capitalized interest. It's like rolling that unpaid interest into the total amount you owe.

But here's the thing: accrued interest doesn't always get turned into capitalized interest. Sometimes, it's just treated as a regular expense that the company has to deal with right away. Like, if you miss a payment on your loan, that unpaid interest might just get counted as an expense right then and there, without waiting around to be added to your loan balance.

So, while accrued interest and capitalized interest can be similar, they're not always the same. It all depends on how the company decides to handle things and what makes the most sense for their financial situation.

What's the Deal with Calculating Capitalized Interest ?

Calculating capitalized interest is pretty much like figuring out any other kind of interest. You start by multiplying the interest rate by the amount of money you owe. Then, you consider how many days the interest is building up for. After that, you add this amount to the original amount you borrowed. It's a good idea to keep track of both your original loan amount and the interest that's been added over time. That way, you can see how much your loan is growing.

How Does Capitalized Interest Work?

When a business buys something that it will use for more than a year, like a big machine, it's called a fixed asset. These assets are listed on the company's balance sheet and gradually lose value over time, a process known as depreciation.

But how do you figure out how much these assets are worth? Well, for simple stuff like a laptop, it's pretty straightforward. You just look at the price tag and that's it.

But for bigger things, like custom-built machines, it gets more complicated. You've got to consider not just the price of the machine itself, but also things like delivery, installation, and maybe even testing.

Now, let's say you're paying for this machine in installments over time. Any interest you pay on those installments gets added to the total cost of the machine. Whether you're paying with cash or using a loan, that interest cost becomes part of the overall price of the machine. This process is called capitalizing the interest.

So, when it comes to big purchases and paying over time, capitalized interest helps make sure the total cost of the asset includes all the expenses, including any interest along the way.

Conclusion

In conclusion, capitalized interest plays a crucial role in accounting for long-term assets, ensuring that the total cost of an asset reflects all associated expenses, including interest incurred during the acquisition or construction process. By adding interest costs to the asset's value, businesses can accurately represent the true cost of acquiring or constructing an asset over time. This practice helps improve financial reporting accuracy and transparency, providing stakeholders with a clearer understanding of a company's financial position and performance.

FAQ's 

Q: When does capitalized interest occur?
Capitalized interest typically occurs in the following situations:

During a grace period: For student loans, mortgages, or other types of loans, borrowers may have a grace period during which they are not required to make payments. However, interest may still accrue during this time and be capitalized if not paid.
During deferment or forbearance: Borrowers who temporarily postpone loan payments due to financial hardship or other reasons may still accrue interest, which can be capitalized if not paid during the deferment or forbearance period.
With certain loan modifications: When borrowers renegotiate the terms of their loans, such as extending the repayment period or changing the interest rate, any unpaid interest may be capitalized and added to the loan balance.

Q: How does capitalized interest affect loan repayment?
Capitalized interest increases the total amount owed on the loan, which can have several implications for loan repayment:

Higher loan balance: Capitalized interest increases the principal balance of the loan, resulting in higher monthly payments or a longer repayment period.
Increased interest costs: With a higher loan balance, borrowers may pay more in interest over the life of the loan compared to if the interest had been paid as it accrued.
Longer repayment period: Capitalized interest may extend the repayment period, especially if borrowers choose to defer interest payments during periods of financial hardship or other circumstances.