Capitalization, in the general financial sense, is the accounting of costs into the overall price of an asset or debt. For instance, if a lender agrees to combine the closing costs for a loan into the loan payments instead of demanding them upfront, this is known as closing cost capitalization. However, there are many different ways a mortgage can be capitalized, although most directly change how a lender treats the mortgage and chooses its terms.
Commercial Mortgages and Capitalization
One of the most important types of capitalization occurs when a lender studies a commercial property and creates a capitalization rate for it when making the mortgage. This capitalization rate is essentially a measurement of the percentage of the property's value that is "earned" by the property during a year of business operations. The income created by a factory in a year would be compared to the cost of the factory to create this rate, although capitalization rate formulas can vary based on how the property produces income and what the mortgage is being used for.
Importance of Cap Rate
Lenders use the cap rate to make decisions concerning the interest rate when making commercial mortgages. For instance, many lenders aim for a 14 percent capitalization rate when offering a loan. The interest rate will fall below that, but it assures the lender that the business will be creating enough money from the property to at least make interest payments. How much lower the interest rate is from the capitalization rate depends on the lender's current mortgage standards.
Other mortgages may also capitalize the interest itself. This is more common in generous individual mortgages where the lender allows the borrower to make minimum payments. These payments are very low but only pay part of the interest accrued each month. This extra interest is capitalized, or added to the principal, which increases the next month's interest payment. Because the mortgage will not be paid off with this capitalizing, capitalizing interest is only a temporary condition at the beginning of a mortgage or a part of a restructuring.
Other lenders will also capitalize mortgage payments. This is a common practice for lenders that modify loans for borrowers that are in debt and cannot make their current mortgage payments. To make the loan current again, the lender will take all unpaid monthly debts in the past and capitalize them, adding them back into the mortgage and requiring them to be paid back eventually as future debts.