Capitalised interest: when the interest becomes part of the debt

Some loans send you a bill every month. Others stay silent for a year, and then the statement arrives showing a balance higher than the amount you borrowed. If that second kind sounds like a trap, it usually isn’t, but it does behave in a way the first kind doesn’t. The thing doing the work is capitalised interest.

Understanding it takes a couple of minutes, and it can save you from the unpleasant surprise of a payout figure that has quietly grown.

What is capitalised interest?

Normally, interest is charged and you pay it, so the balance stays put. With capitalisation, the interest is charged, but rather than collecting it, the lender adds it to the loan. The principal becomes bigger. The next round of interest is then worked out on the new, bigger number.

Our glossary entry on capitalised interest gives the short definition. In practice, three words capture it: added, not paid.

It appears most often in:

• Construction and development finance, where there is no income until the project sells
• Bridging and some short-term property loans, repaid from a sale or refinance
• Some loans with a deliberate repayment holiday at the start
• Arrears, where unpaid interest may be capitalised by the lender under the contract

How much extra does it cost? A worked example

Here is an illustrative comparison. A developer borrows $200k for 12 months. Interest comes to $2,000 a month at the lender’s pricing. The figures are examples, not a quote.

Option one: pay the interest each month. Balance stays at $200,000. Over 12 months the developer pays $24,000 in interest, and then repays the $200,000.

Option two: capitalise the interest monthly. Nothing is paid during the year. Each month the interest is calculated on a bigger balance, so the monthly charge grows.

End of month	Balance (option two)
0	$200,000
3	$206,060
6	$212,304
9	$218,738
12	$225,365

At the end of the year the developer owes $225,365. The total interest is $25,365, which is $1,365 more than option one.

That $1,365 is the price of not paying $2,000 a month during the year. It’s modest over twelve months, and for a developer short of cash it may be money well spent. The effect increases with time: over two years at the same pricing the extra is several times larger, because each month’s interest is calculated on a bigger and bigger base. If you want to understand why, our guide to simple versus compound interest explains the arithmetic.

Why the loan-to-value ratio matters

There is a second effect that has nothing to do with cost: your headroom shrinks.

If the $200k loan is secured on a property worth $400k, the loan-to-value ratio (LVR) starts at 50%. After a year of capitalising, the balance is $225,365, so the LVR is about 56%. Nothing happened to the property. The debt just grew.

For most borrowers that’s fine. But if the lender’s maximum LVR is, say, 60%, a longer capitalising period or a fall in the property’s value might leave you with no margin. A valuation that comes in lower than expected can put you in breach of a loan condition or stop you refinancing when you planned to. Run your own numbers in the LVR calculator, and read why lenders care in our guide to LVR.

Want a real person to check whether the structure you’re offered leaves enough headroom? You can start an enquiry here.

Capitalised, prepaid or interest-only: what is the difference?

All three take monthly interest payments off your plate for a time, but they work differently.

	Interest-only	Capitalised	Prepaid
Who pays the interest, and when	You, every month	Added to the balance; paid at the end	Deducted from the loan at settlement
Balance during the period	Same as borrowed	Rises	Same as borrowed (after deduction)
Cash you receive at the start	Full amount	Full amount	Less than the loan amount
Monthly cash out	Interest	Nothing	Nothing
Main catch	Principal shock later	Compounding and LVR creep	Smaller advance; refund questions

For more detail, see interest-only business loans explained and prepaid interest loans explained.

When does capitalising make sense?

It is a sensible tool when:

• The business has no income from the funded project until it finishes or sells
• The exit is solid, such as a presale, a signed contract or an agreed refinance
• There’s plenty of equity cushion, so the growing balance doesn’t threaten the LVR
• The period is short, so compounding has little time to build

It deserves caution when:

• The loan is long and the exit is uncertain
• The security is already close to the lender’s limit
• You’re capitalising because you can’t make payments, which turns a short loan into a growing problem

If a bank offers a facility with a capitalisation period for a clear purpose and you fit its criteria, it’s worth taking seriously, because banks are often the cheapest money. Where a bank has declined, specialist lenders in the construction and bridging space often use capitalising structures routinely, and our page on construction and development finance explains how those loans are structured.

What should you ask your lender?

Capitalised interest is allowed and common. What matters is that you know the figures. Ask in writing:

1. How often is interest capitalised? Monthly capitalising costs more than quarterly, and that difference is just arithmetic.
2. What will the balance be on each of the next 12 dates? A schedule is better than an estimate.
3. What is the payout figure at the end date? Make sure it includes all fees.
4. What LVR does the balance reach at the end? Compare it with the lender’s limit.
5. Can I pay interest from my own cash if I choose? Partial payments reduce the compounding.
6. What happens if the project runs late? Extension fees and default interest can stack on top of a growing balance.

For the contract itself, small businesses also have some protection against one-sided terms. ASIC explains that the unfair contract terms rules apply to many small business loans, though the headline price is excluded. A clause that allows capitalising in unexpected circumstances is worth querying before you sign.

Is capitalised interest deductible?

Interest on money borrowed to produce business income is generally deductible. When interest is capitalised, the timing and treatment need more care than with an ordinary monthly payment, particularly for property development, where interest can sometimes form part of the cost of the asset instead. This varies with your structure and what the loan funds, so confirm it with your accountant before you rely on it in your cash flow.

Could a smaller step help?

Often the best answer is partway. If you can afford to pay some of the interest each month, even a portion, the balance grows slower and compounding does less damage. A hybrid is common: pay for a while, capitalise for a stretch, then revert. Ask the lender what structures are available and price each in dollars using the true cost method.

Is a growing balance on your radar?

If you’re looking at a loan where interest will be added to the balance, it’s worth having someone talk the numbers through with you before you sign. Tell us about the project on our form. It takes roughly a minute, and enquiring leaves your credit file exactly as it was. We keep your details to ourselves rather than circulating them to many lenders. A real person reads your enquiry and rings you. Be precise about the amount, the security’s value and your exit, and the first lender or structure we suggest is more likely to be the right one.

See what structure fits →