Capitalized Interest: Definition, How It Works, and Example

Capitalized interest refers to the interest that accrues on a loan or investment, which is then added to the principal balance. This means that instead of paying interest as it accrues, it gets added to the total amount borrowed or invested, and interest is then calculated on this new higher amount.

Here's how it works:

Accrual of Interest: Interest starts accruing on the principal amount of the loan or investment. However, instead of being paid immediately, it's allowed to accumulate.
Addition to Principal: At certain intervals, typically at the end of a specific period like a month or a year, the accrued interest is added to the principal balance. This new total becomes the basis for calculating future interest.
Compound Interest Effect: By adding the interest to the principal, future interest calculations are based on this larger amount. This leads to a compounding effect where interest is charged on both the original principal and the accumulated interest. Generally, compound interest is defined as interest that is earned not solely on the initial amount invested but also on any further interest.

Example: Let's say you borrow $10,000 at a 5% annual interest rate with capitalized interest, and the interest is capitalized annually. After the first year, you'll owe $10,500 ($10,000 principal + $500 interest). Instead of paying off the $500 in interest, it gets added to the principal. So, in the second year, you'll be charged 5% interest on $10,500, resulting in $525 in interest. At the end of the second year, your total debt will be $11,025 ($10,500 principal + $525 interest), and so on.

Capitalized interest is commonly seen in student loans, where interest accrues while the borrower is in school and is added to the principal upon graduation or when repayment begins. It's also prevalent in construction loans and mortgages during the construction phase, where interest payments are deferred until the project is complete.