If you have ever taken out a student loan or are aware of accounting practices, you will likely have encountered ‘capitalized interest’. Right off the bat, it is easy to assume that this is related to interest rates, but the fact is there is more to it than that. While there is a connection, it is buried under layers of other facets.
What is it?
‘Capitalized interest’ refers to the cost of borrowing to obtain or build a long-term asset. In contrast to an interest expense incurred for any other reason, capitalized interest is not immediately expensed on the income statement of a company’s financial statements. Firms instead capitalize it, meaning that the paid interest boosts the cost basis of the associated long-term asset on the balance sheet.
Capitalized interest appears mainly in installments on a company’s income statement. Specifically, through occasional depreciation expenses documented on the related long-term asset throughout its life.
It is important to remember that sooner or later, you will need to pay capitalized interest charges. Furthermore, you will need to pay additional interest when you capitalize. This change occurs in the form of higher monthly payments or payments that last longer than they would otherwise.
Capitalized interest is part of the traditional cost of receiving assets that will be beneficial to a company for many years. A lot of companies use debt to finance the construction of long-term assets, so ‘Generally Accepted Accounting Principles’ (GAAP) permits firms to dodge expensing interest on this debt. They can then include it on their balance sheets as part of the historical long-term asset cost.
Time to repay
A common application of capitalized interest is with student loans. Students may not care that much if their loan balance increases each month. However, a bigger loan balance will have an effect on you in years to come. For that matter, it also means that you will pay more interest throughout the rest of your loan’s life.
Setting aside any one-time fees, the cost of a loan is the interest you pay. Put simply, you repay what they gave you along with a little extra. The driving forces of your total cost are the following:
- The amount you borrow: A higher loan balance means more interest for you to pay.
- The interest rate: A higher rate means that it is more expensive to borrow
- The amount of time it takes for you to repay the loan: The longer you take to repay the loan, the more likely it is that your lender will charge interest.
Indeed, you might not have a lot of control over the interest rate, particularly with federal student loans. Nevertheless, you can control the amount you borrow. On top of that, you can prevent that amount from increasing. However, if you capitalize the interest, your monthly payments, as well as lifetime interest costs, will grow.
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