What Does "Capitalized Interest" Mean?

Capitalized interest may apply to certain long-term loans that, when borrowed, are scheduled to have a delay in repayment for a specified reason. The lender and borrower generally agree upon approved reasons for payment delay at the time of the loan. During the time payments are deferred, the amount of interest that would have been paid during the deferment period, had the loan been in repayment, is totaled. The amount is then added to the principal balance of the loan. Because interest is charged based on the principal balance, a borrower eventually pays interest on the capitalized interest when the loan goes back into repayment. There are several common scenarios that recognize capitalized interest.

Student Loans

Most student loans involve capitalized interest. The loans a student receives for educational use are not placed in repayment status until six months after the student stops going to school, either as a result of graduation or withdrawal from courses. Interest that would have been due if the student was making payments on the loan while in school are capitalized and structured into the student's repayment plan.

Building Projects

When companies borrow money to build a long-term asset, such as a new building, the interest on the loan is capitalized during periods where the project is not available for use. In scenarios where a project requires multiple loans and various phases of building, capitalized interest may stop accruing on phases that are complete and ready for use. The loans on these phases may become payable as other phases of the project are still under construction.

Accounting for Capitalized Interest

Accountants must account for capitalized interest differently than normal interest expenses. Because capitalized interest is not immediately due and payable, as regular interest is in conventional loans, accountants must add the capitalized interest to the cost or value of the asset that funds were borrowed for to acquire. The total value of the asset is then listed as an asset of the business. Capitalized interest expenses are then accounted for over time through depreciation.

Avoiding Capitalization

Capitalized interest may be an unfavorable expense to many borrowers since it creates additional costs over time. Some lenders may give borrowers an opportunity to pay accrued interest before it is capitalized and added to the principal balance of the loan. If you take out a loan that allows capitalized interest accruals and you can afford to pay the accrued interest before your regular loan payments commence, you will save money over the life of the repayment by paying the interest before it is capitalized.