Accrued interest is the interest payable on different types of debts and fixed-income securities, such as bonds and credit card debts.
On the other hand, capitalized interest generally refers to the portion of accrued interest that is yet to be paid, which is added to the balance borrowers still owe. However, it has different implications, depending on the financial context in which you are using the phrase. For example, the Department of Education capitalizes interest for unsubsidized student loans, while businesses capitalize interest for the cost of self-constructed assets.
What Is Accrued Interest?
According to Investor.gov, accrued interest is any interest that has been earned according to the specified interest rate but has not been paid yet by the borrower to the investor. However, the borrowers may vary. If you have a credit card balance that you have not paid, you are the borrower. On the other hand, if a business obtains money from investors or lenders, it becomes the borrower.
Bonds are an example of a fixed-income security, which is typically an investment that pays you, the lender or investor, at regular intervals based on specific interest rate until the security reaches its maturity date. They are issued by institutions, such as business corporations or governments, which need money to achieve various financial goals.
Typically, the issuers of these securities make interest payments to investors every 30 days, or once every six months. The interest accrues between payment dates, but isn’t paid until the actual date arrives. Then, the issuer makes one payment for all the months the bond accrued interest. That way, if your payment dates are once every six months, the issuer pays you six months’ worth of accrued interest in one lump sum on each payment date.
What Is an Example of Accrued Interest?
Suppose you borrow a loan worth $100,000 from someone at an interest rate of 6 percent per annum, payable bi-annually. In one year, the entire loan would require you to pay interest of (6/100) $100,000, which is $6,000. That translates to monthly payments of $500. So, if you were to account for the accrued interest within half a year, it would be $5006, which is $3,000.
What Is Capitalized Interest?
Capitalized interest is the unpaid interest that is added to a loan’s principal balance.
Federal Student Aid discusses the difference between subsidized and unsubsidized loans, available for federal student loan applicants.
For example, while you are in school, the government doesn’t charge you interest on subsidized loans, but does charge you student loan interest for unsubsidized loans. You can opt to pay your interest on your unsubsidized loans while you are in school even if you have a grace period.
But if you choose not to pay then or opt for periods of deferment later, the government then capitalizes your interest payments by adding them into your principal loan amount, making it bigger and causing the repayment to become more challenging.
What Is an Example of Capitalized Interest?
Below is a student loan example to show how paying interest works when capitalization happens:
Suppose you have a $5,000 unsubsidized loan your first year of school with monthly interest payments of $10 per month. You opt not to make these student loan payments throughout the year and watch as the clock runs out on your grace period, making your total interest charges $120.
In that case, your accrued interest is $120. The total amount of interest will be added to the principal you have yet to pay. So, in your second year, your principal loan balance becomes $5,120. The government will then begin charging you interest on your original loan of $5,000 plus the capitalized interest amount of $120.
So, you will need to work harder during the repayment period for the entire life of the loan to get rid of your accumulated debt because it will be subject to compound interest that works against your interests. Further, the federal government doesn't have a refinance option for student loans, so that would need done privately. This is all why it pays to look at the lifetime interest costs before taking any debts, including private student loans.
It is worth noting, though, that the current government has made some changes to the interest capitalization for student loans. When you first enter repayment, exit forbearance or leave most income-driven repayment plans, such as Pay As You Earn (PAYE), you may not have to deal with capitalized interest. However, you still have to deal with the interest capitalization when leaving the Income-Based Repayment (IBR) plan.
Capitalized Interest Accounting
Capitalized interest in accounting works much in the same way as the capitalized interest for student loans.
When a company obtains a loan to pay for a long-term asset, it is a self-constructed asset. Rather than one bought from an outside party, it capitalizes the interest on the loan by adding the interest to the total cost of the project. The cost of the loan for constructing the asset plus the capitalized interest is what the company reports as the total cost of the project on its balance sheet.
This article was written by PocketSense staff. If you have any questions, please reach out to us on our contact us page.