Capitalized interest is when lenders defer interest payments on loans, allowing borrowers to avoid repayment until they earn money from the invested funds. Businesses must meet three requirements to apply for a compound interest loan, while students often face negative consequences with compounded interest on education loans.
Capitalized interest is a process in which 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 do not earn money from the invested funds. Cons are also present with interest capitalized as the principal balance typically increases for the borrower, increasing future payments. When businesses borrow funds and apply for a compound interest loan, 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 capitalized interest loans include: interest incurred on the loan, business activities that ensure the asset meets its intended use, and specific expenses incurred for the asset in question. When a business loan meets all three of these requirements, it can account for interest by compounding it instead of spending it. Capitalization in these terms means adding the amount of interest to the value of the asset listed on the loan documentation. The benefit is that the interest will add to the financial wealth of the company, especially once the company repays the loan and the debt is off the company’s books.
For individuals, capitalized interest is common on education loans. Students are not required to repay the loans until they graduate or stop attending school for other reasons. The lender servicing the education loan often sends statements indicating the interest amounts capitalized for the loan. The interest will require repayment along with any future interest on the loan.
The drawbacks of compounded interest are often more negative for individuals than for businesses. For example, student loans will continue to accrue interest as long as the borrower remains in college. Extending the number of years to complete the title will result in higher amounts of capitalized interest, added to the principal balance, on the loan. This will significantly increase the principal balance, thus increasing future interest payments for the loans. Once the student starts paying, the payments generally go against current interest and then interest capitalized. The original principal balance will not be reduced until the capitalized interest portion is paid in full. Businesses generally don’t face this problem because they often have more money to repay the loan faster than people.
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