Interest Capitalization
Interest capitalization is a process of including debt interest payments into the value of a loan. This can be used to pay the interest payments on an existing loan or for a new loan. In most cases, the interest payments are added to the principal balance of the loan and the borrower repays this capitalized loan amount over the initial loan term. Interest capitalization can also stretch out the life of the loan and increase the overall cost of borrowing for the borrower. As a result, borrowers should understand the importance of understanding how interest capitalization works before deciding to include it in the terms of a loan.
Interest capitalization happens when the lender decides to add interest payments to the principal balance of a loan. The lender then adjusts the loan’s repayment schedule and the borrower pays back the new capitalized amount over the remainder of the loan’s term. This process is normally done to increase the liquidity of a borrower, as they are able to use current cash flow to pay interest payments.
Interest capitalization is a helpful tool for borrowers who are unable to make their existing loan payments due to cashflow constraints. For example, if a borrower who is short on cash and unable to make their debt payments, it is possible for the lender to capitalize the interest payments. In this case, the interest payments are added to the principal balance of the loan, and the borrower pays a new monthly payment based on the new capitalized loan amount.
When using interest capitalization, it is important to understand how it affects the overall cost of borrowing. The process of capitalizing monthly interest payments leads to a smaller monthly payment. This may appear to be a positive, however, it may lead to a higher overall cost of borrowing due to an increased amortization period. When interest payments are capitalized, the total amount the borrower must repay is increased and the repayment period becomes longer. Additionally, interest rates may increase over time, so the overall cost of borrowing can be significantly higher.
In order for a borrower to understand the full cost of interest capitalization, it is important for them to calculate the impact of including debt payments into their principal balance. This can be done by adding the total amount of interest payments to the existing principal balance of the loan. Once the borrower has this total amount, they can use it to calculate the new repayment period and interest rates associated with the loan.
Overall, interest capitalization can provide a financial benefit to borrowers who are in need of extra liquidity. However, it is important to understand the full terms of the loan in order to calculate the impact of including interest payments into the principal balance of the loan. By taking into account the cost of borrowing and the repayment period associated with the loan, borrowers will be able to determine if interest capitalization is the right option for them.
