Interest capitalisation occurs when interest is added to the total loan amount or ‘principal’ of a loan but isn’t immediately paid back on an ongoing basis to the lender.
Allowing interest to capitalise can be a necessity for some borrowers in the event of financial hardship in order to reduce the size of, or completely pause, your loan payments for a period of time. In addition, this approach can be built into some investment loan agreements from the start. Not only does this increase the amount of debt, but it leads to compound interest, where interest is charged on the capitalised interest.
Interest capitalisation works by allowing a principal-and-interest borrower to temporarily stop paying off the interest that is being added to their loan for a period. A lender will then take this added interest into account when calculating interest on the new loan balance in the next period. This is known as compounding interest or paying interest on existing interest.
Interest Capitalisation is normally for a particular period of time – such as 3, 6 or 12 months. In some cases, it can be for more than one year.
Interest Capitalisation can provide the benefit of improving your cash flow because you don’t need to pay the interest on the property; so you can then use that cash for something else. However, it is important to remember that while you are improving your cash flow, your interest costs are compounding over time. It’s much the same as how compound interest on savings works, except you are being charged interest on your interest rather than earning it.
Here’s a basic CASE STUDY that displays the extra interest a three month home loan holiday would add to a $500,000 home loan, as well as what you’d need to increase your monthly repayment to after the repayment holiday, in order to repay it within the same 30-year term.
Due to COVID, Bob would like to take a six-month mortgage repayment holiday from his recently established home loan.
Bob’s loan balance is $500,000 and he has 30 years left on the mortgage. The interest rate for this loan is 5.00% and his minimum monthly principal and interest repayments are $2,684.
If Bob makes no repayments during the six-month repayment holiday and the interest is capitalized, the loan balance after this six-month period will be $504,175. When his repayments are reinstated his new repayment amount will increase to $2,710 and he will maintain the same loan maturity date.
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