Updated July 10, 2023
Definition of Capitalized Interest
Capitalized interest is a term that businesses or individuals use when borrowing funds or taking loans, respectively. The interest costs add to the assets or principal amount and increase the cost-basis of the concerned assets on the balance sheet.
Companies incur the cost of financing an asset, where they levy interest on the useful life of the asset, and the borrower demonstrates the interest expense by showing periodic depreciation expense on the asset.
It is different from other interest expenses based on incurrence and duration. Otherwise, people commonly use the two interchangeably. As the term suggests, capitalized interest becomes capital in the business’s balance sheet. Depreciation schedules expense the added cost of raising fixed assets. 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 on 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?
The table states interest expenses, calculated based on the applicable interest rates. We need to capitalize these expenses over a certain time 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 depending on the loaned expenses.
When is Interest Capitalized?
Certain conditions capitalize the interest.
- 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. Interest accrual still occurs when small businesses defer loan repayments to a later date.
- When the borrower’s income eligibility changes, the capitalization scheme comes into effect in specific cases.
How to Avoid Capitalized Interest?
Starting loan repayment early can help individuals and businesses avoid capitalizing interest. Interest capitalization in businesses involves complex regulations and standards, and the decision to capitalize on interest expenses is always made on a case-by-case basis.
Early payments in the form of EMIs can help avoid the capitalization of student loans. Students can also use subsidized loans, which, although they restrict borrowing capacity, make ease of payment by introducing lower interest rates. Exhausting subsidized loan limits (mostly federal) is always a good choice before moving to other commercial loan options.
Capitalized Interest vs Interest
Compound interest generally applies to capitalized interest, while interest other than capitalized interest can be either compound or simple. Compound interest considers the periods involved in the loan tenor, while simple interest does not do so. Below is a simple example to distinguish between the two:
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.
Some of the advantages are as follows :
- 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, scheduling it with depreciation charges. Adding back depreciation as a non-cash charge relieves the company when it is liable for higher taxes.
- 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 as follows :
- 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 the Financial Accounting Standards Board prescribes. In US GAAP, the interest capitalized as a part of the asset cost is known as a capitalized asset.
It is important to note that the capitalization of interest depends on the qualifying value of the asset under consideration, and not all interest costs can be capitalized. Identifying a qualifying 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 –