Definition of Capitalized Interest
Capitalized interest is a term of interest that businesses or individuals use when borrowing funds or taking loans, respectively. The interest costs are added to the assets or principal amount and increase the cost-basis of the concerned assets on the balance sheet.
It is the cost of financing an asset incurred by companies such that the interest is levied on the useful life of the asset and the borrower shows up the interest expense through periodic depreciation expense on the asset.
It is different from other interest expenses based on incurrence and duration. Otherwise, the two are commonly used interchangeably. As the term suggests, capitalized interest becomes capital in the business’s balance sheet. It is an added expense on raising the fixed assets and is expensed through depreciation schedules. In the context of student loans, it plays a crucial part. Some of the discussion in this article will be based on this aspect.
Example of Capitalized Interest
Suppose that ABC Ltd. has taken a project of building a power plant for its factory. The business takes a loan and prepares an expense schedule based on the interest rate levied. What should be the capitalization expense that can be drawn basis the expense schedule?
To simplify, interest expenses are calculated based on the applicable interest rates and are stated in the table as expenses. We need to capitalize these expenses over a time certain period
We will first calculate the capitalization period to calculate capitalized interest expense based on the expenses provided.
- The capitalization period is the period for which the expense will be capitalized.
- Then we allow weightage to each of the capitalized items
- Finally, we calculated capitalized interest expense based on the period and weightage
|Date||Expenses (A)||Capitalization period (B)||Weightage (C) = (B / 12)||Capitalization Expense (D) = (C* A)|
Thus, an interest expense of $205,833.33 will be capitalized based on the loaned expenses.
When is Interest Capitalized?
Interest is capitalized in certain conditions, some of which are:
- When the duration of relief has ended – Suppose that a student loan was taken on Jan 1, 2020, and the grace period ends on Jan 1, 2022. The interest will start capitalizing from Jan 2, 2022, onwards
- Interest can also start capitalizing on the total value of the loan when the forbearance period ends. However, when small businesses defer loan repayments to a later date, the interest still gets accrued.
- In specific cases, when the borrower’s income eligibility changes, the capitalization scheme comes into effect.
How to Avoid Capitalized Interest?
Capitalized interest in businesses and student loans can be avoided by starting loan repayment as early as possible. While businesses have complex regulations and standards associated with interest capitalization, it is always decided on a case-to-case basis as to whether interest expense should be capitalized or not.
Student loans can be avoided from capitalization using early payments in the form of EMIs. Students can also use subsidized loans, which, although they restrict borrowing capacity, make ease of payment by introducing lower interest rates. It is always a good choice to exhaust subsidized loan limits (mostly federal) before moving to other commercial loan options.
Capitalized Interest vs Interest
Capitalized interest is generally compound interest, while interest other than capitalized interest can be either compound or simple interest. Compound interest considers the periods involved in the loan tenor, while a simple interest does not do so. Below is a simple example to distinguish between the two:
Amount Payable (Principal Plus Interest) = Principal + (principal * Rate * Time)/100
A loan of $10,000 at 10 percent annual simple interest to be paid over the next five years will generate interest of $5,000 per year. If monthly compound interest is levied and capitalized on the loan asset, the compound interest payable is $6453. Capitalization, in simple terms, will attach the interest payable with the principal amount.
Amount Payable (Principal Plus Interest) = Principal * (1 + Rate/12) ^ (12 * Time Period)
Some of the advantages are given below:
- Since companies can defer interest expenses to succeeding accounting periods, the tax purpose needs to use capitalized interest on assets
- It provides for associating the interest expenses with assets on a cost-basis, thereby scheduling it with depreciation charges. This relieves the company when it is liable for higher taxes as depreciation is a non-cash charge added back.
- Students who opt for capitalized interest schemes are provided with the benefit of not having to repay the loan until they complete their studies for which they have loaned the amount. This leaves them sufficient funds at their disposal to carry out other expenses.
Some of the disadvantages are given below:
- With the benefit of capitalizing interest on assets comes the drawback of preceding the tax benefits in the period companies have loaned for raising the asset. This is because the interest is deferred to succeeding periods.
- In the case of student loans, it increases the loan repayment and is calculable based on the deferment of interest payments. However, this means that a student will have to face a bigger loan outstanding and repay a bigger EMI (equated monthly installments) if he chooses capitalization interest schemes.
It has a different standard called Statement of Financial Accounting Standards, numbered 34 as prescribed by the Financial Accounting Standards Board. In US GAAP, the interest capitalized as a part of the asset cost is known as a capitalized asset.
When considering capitalization of interest, it should be noted that not all interest costs can be capitalized as it depends on the qualifying value of the asset in consideration. Identifying a qualifying asset (an asset for which borrowing cost is permitted) is always essential. Businesses must validate the impact of interest capitalization on liabilities and working capital.
This is a guide to Capitalized Interest. Here we also discuss the definition, how to avoid capitalized interest, advantages, and disadvantages. You may also have a look at the following articles to learn more –