Capitalised interest is unpaid interest added to the principal on a loan. This process is known as capitalisation.
If you are struggling with mortgage stress, you may be able to pause the interest repayments and only reduce the principal. Your repayments will be lower during this pause, as you aren’t paying any interest. However, your lender will add this unpaid interest to your loan’s principal.
Your lender will then recalculate your interest repayments based on this increased balance, increasing your future repayments. When your unpaid interest capitalises, the amount you owe increases.
Simply put, any interest you don’t pay during this pause will be added back onto your loan by your lender. So, you will still have to pay down the track. It may give you some temporary relief in times of financial hardship, but you will pay more in total.
» MORE: How to pay off your mortgage faster
How does capitalised interest work on a mortgage?
Capitalisation can occur on a mortgage or home loan. Generally, a home loan is made of two parts: the principal, the amount you borrow, and the interest, which is what your lender charges you to borrow the money.
Each repayment period, you make payments to your bank or lender each repayment period to reduce the principal. You also pay interest based on the size of your loan. If you are struggling to make these repayments, you may be able to temporarily pause the interest portion of your repayments to make each instalment more affordable.
However, you don’t avoid paying interest altogether. Instead, you are essentially kicking the can down the road, and the unpaid interest goes back into the principal portion of your mortgage. As a result, you’ll pay more in the long term because the more principal remaining on your loan, the more interest you pay.
It’s important to understand how capitalisation can impact you before you end up in financial hardship and, if possible, try to avoid it.
If you are struggling to meet your home loan repayments — or are at risk of missing a repayment — you should notify your lender to find out what alternatives are available. Missing repayments can impact your credit score and put you at risk of defaulting on your mortgage.
» MORE: How to avoid mortgage stress
Example of capitalised interest:
Susan has a $400,000 mortgage. If her interest rate is 5% and the loan term is 25 years, her usual repayments would be $2,338 per month. If Susan fulfils her loan requirements, she will pay $301,508 in interest over the life of this loan.
After some time, she has paid off $50,000 of her principal. However, she cannot meet her monthly repayments as she was injured and unable to work for six months.
Instead of her usual repayments, she pays $1,338 a month for these six months. The interest she doesn’t pay during that period capitalises on her home loan. This capitalisation period could add approximately $4,523 in interest to her total loan, which she will pay off during the loan period. So, her future monthly repayments are now higher than the $2,338 she used to pay.
This hypothetical scenario uses simplified calculations and assumptions on an unchanging interest rate. Individual circumstances and market fluctuations would change these costs. However, this illustrates the potential future cost of even a six-month pause in the interest portion of your mortgage.
How to avoid paying capitalised interest
There are a few alternatives to paying capitalised interest on your home loan. Talk to your lender first to see what they can do for you or what they recommend.
Some options may be:
- Short-term lowering of repayments. Sometimes, you can go on a reduced payment plan for a short time. Eligibility will depend on your situation and your lender, but they may allow you to make smaller repayments to help you avoid default.
- Interest-only repayments. Some lenders may allow you to switch your repayments to ‘interest only’. However, this means you won’t reduce your principal, so it is a risky alternative.
- Refinancing. If you have a high interest rate, refinancing to a mortgage with a lower rate may help. This move could reduce your repayments and total interest over the life of the loan.
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