A capitalized interest loan is a type of credit in which: its interest is capitalized, because it is calculated not only on the principal, but also on the interest added to the original debt.
The accrued interest, in this way, is added to the initial principal, producing in turn new interest.
In other words, interest capitalizes when you add it to the initial principal that produced it, rather than when it is paid or collected.
This implies that, as interest accrues, the amount will be reused as initial capital for the following period. In other words, interest also earns interest.
This is the exact answer to the question posed in the title. But as it always happens, when we talk about an intricate subject, it is necessary to explain the explanation.
In this article, we will teach you more clearly how interest compounding works and how to deal with it.
Semantic breakdown of capitalized interest loan
When we talk about capital, we mean the value invested in us, or the money we have borrowed.
So, when we talk about capitalization, we mean that we are going to add interest to the initial capital.
Interest refers to the amount that the debtor must pay for the use of the credit granted. Or, in other words, it corresponds to the lender’s compensation after the loan has been disbursed.
Interest is calculated on a monthly, bimonthly, quarterly or semiannual basis, but this will be discussed later.
A loan is a transfer of money, with a commitment that the recipient will repay an equivalent or greater amount.
Now let’s summarize these definitions: A loan with capitalized interest refers to the fact that, from the amount that was originally loaned to us, interest must be paid and, in addition, from that interest, interest must also be paid.
This is known in financial mathematics as a compound interest rate.
How does borrowing with compound interest work?
In the world of finance, when we talk about capitalization, there are two types: simple capitalization and compound capitalization.
H3 Simple capitalization or simple interest rate
With this type of rate, the final amount to be earned by the lender does not accumulate and is not very productive for the lender.
Recall that, in any economy, financial experts always seek to protect themselves from inflation.
The only advantage of this model is that the creditor can enjoy his commission at the end of each established period.
Compound capitalization or compound interest rate
On the contrary, this type of interest rate is productive, because the amounts accumulate as time goes by. That is to say, it joins together with the capital to continue generating interest throughout the following period.
Its disadvantage, just the opposite of the previous one, is that the creditor will not be able to dispose of the final profit until the end of the established period. That is, at the end of the amortization.
What is the capitalization rate?
The capitalization rate is the relationship between the annual income and the value of the property. There are two types: nominal and effective capitalization.
This generates interest several times a year. It is commonly used as a reference value among financial processes, and is established by the authorities to maintain control over loans and deposits.
It is called “nominal” because the rate presented is on an annual basis. But there are also other terms, in which we will be told how many times it is capitalized per year.
This capitalization is executed only on a monthly, quarterly and semi-annual basis. In addition, it generates higher interest and higher earnings than on an annual basis.
Why do creditors resort to borrowing with capitalized interest?
Lenders are always exposed to the risk of not recovering the money they lend. But what exactly are the risks to which the lender is exposed? There are 3 types:
This risk simply consists of the borrower’s inability to repay the money within the established time frame.
There is also the risk that, between the delivery of the loan and the current time, a law arises that stipulates that the agreed amounts must no longer be paid.
As we indicated in the point of simple capitalization or simple interest rate, there is always the risk that, at the end of the repayment term, the amount repaid will not be equal to what it was worth when the loan was agreed.
For this reason, and in order to make loans profitable, compound interest rates have emerged. An option that does not always represent higher profits for the creditor, but simply the safe recovery of his initial investment.
We can conclude that the loan with capitalized interest is a financial tool with which great care must be taken.
In some cases, the lender must use it to guarantee a return. But there are also people who use it for fraudulent purposes, to earn much more than what was agreed.
Capitalization takes place in the context of financial transactions of any kind, such as lending and financing operations.
If you come across this interest rate in a contract, the best thing to do is to seek professional advice.
Mon Petit Prêt will always be available to give you the best attention and get you the contract that best suits your pocket. Visit our website for more information.