Understanding capitalised interest, interest in advance and prepaid interest

July 02 2024 by Andy Wong

Interest is a fundamental concept in finance, shaping the dynamics of loans, investments and various financial instruments. Understanding the nuances of different interest payment structures is crucial for both borrowers and investors, especially during this period of uncertainty around the RBA cash rate. Capitalised interest, interest in advance and prepaid interest are among the many forms of interest payment structures, and each structure has a different impact to project financing and short-term lending. This article aims to highlight the benefits and risks of these three types of interest payment structures, providing a comprehensive review for real estate professionals, property investors, lenders and borrowers.

Capitalised Interest

Capitalised interest refers to interest that is added to the principal balance of a loan rather than being paid off immediately. This process is common in long-term projects such as construction or major capital expenditures, where the asset being financed will take time to generate revenue. By capitalising interest, borrowers can delay interest payments until the project is complete and begins to generate income.

How It Works

Initial Loan Disbursement: When a loan is taken out, the borrower receives the net principal amount (after all fees are deducted) which is used to finance a project. The lender, however, usually calculates interest on the principal amount, which includes all fees charged to the borrower at that point in time.

Interest Accrual: As the project progresses, interest on the loan accrues. Instead of requiring the borrower to make regular interest payments, this interest is added to the loan's principal balance. In other words, interest is charged on interest already accrued for the previous months and keeps compounding until the loan term ends. The lender may choose different compounding methodologies, but it is usually monthly, meaning that interest at the end of each month is added to the loan principal balance.

Completion and Repayment: Once the project is completed and starts generating revenue, the borrower can repay the loan, now consisting of the original principal plus the capitalised interest.

Example

Consider a construction company that takes out a $1,200,000 loan principal to build a new facility on the 1 March 2020. The lender charges total fees of $200,000 when the loan is disbursed to the company, effectively resulting in the net principal amount of $1,000,000. Interest is capitalised and compounded monthly over two years at 8.5% p.a. Instead of paying this interest during the construction phase, it is added to the loan balance at the end of every month. At the end of March 2020, interest is calculated as follows:

\begin{align}\text{Formula} & = {\text{Loan Principal Balance} \times \text{Interest Rate} \over \text{365} \times \text{Number of days in March 2020}}\\& = {\text{\$1,200,000} \times \text{8.5%} \over \text{365} \times \text{31}}\\& = {\text{\$8,663.01}}\end{align}

At the end of April 2020, interest is calculated as follows (with the interest of last month added to the loan's principal balance):

\begin{align}\text{Formula} & = {\text{Loan Principal Balance} \times \text{Interest Rate} \over \text{365} \times \text{Number of days in April 2020}}\\& = {\text{(\$1,200,000 + \$8,663.01)} \times \text{8.5%} \over \text{365} \times \text{30}}\\& = {\text{\$8,444.08}}\end{align}

At the end of May 2020, interest is calculated as follows (with the interest of last month added to the loan's principal balance):

\begin{align}\text{Formula} & = {\text{Loan Principal Balance} \times \text{Interest Rate} \over \text{365} \times \text{Number of days in May 2020}}\\& = {\text{(\$1,200,000 + \$8,663.01 + \$8,444.08)} \times \text{8.5%} \over \text{365} \times \text{31}}\\& = {\text{\$8,786.51}}\end{align}

Even though the months of May and March have the same number of days (31), the interest calculated for May is higher than interest calculated for March. This is due to the compounding effect, where interest for May includes interest calculated on interest for March and April, as the interest for these two months are added to the loan's principal balance.

Despite the compounding effect, the underlying interest formula remains the same:

Loan Principal Balance X Interest Rate / 365 X number of days in the month

\begin{align}\text{Formula} & = {\text{Loan Principal Balance} \times \text{Interest Rate} \over \text{365} \times \text{Number of days in the month}}\end{align}

The full example principal balance and interest schedule can be viewed below:

Benefits and Drawbacks

Benefits:

• Eases cash flow during the project's non-revenue generating phase.

• Aligns interest payments with the project's revenue generation timeline.

Drawbacks:

• Increases the total amount owed due to compounded interest. The borrower must make sure that the consequences of capitalised interest is understood and can reflect this in the feasibility study.

• May result in higher debt levels, potentially impacting creditworthiness.

Practical Applications

Capitalised interest is particularly beneficial for large-scale infrastructure projects, real estate developments and other capital-intensive ventures where the construction period can be protracted. For instance, in public-private partnerships for infrastructure development, the private entity may capitalise interest during the construction phase, thereby deferring payments until the project becomes operational. This practice aligns the financial outflows with the project's revenue generation, making it a viable strategy for managing large-scale investments.

Lender Considerations

Non-bank lenders would raise the loan principal of $1,200,000 from investors. As interest is capitalised throughout the loan term and the borrower does not make regular interest payments, the lenders will also not pay their investors their respective interest/coupon on their investment until the borrower makes full payment of interest and principal at the end of the loan term.

Depending on the lenders, they may also choose to have interest capitalised for their investors as well, thereby allowing their investors to earn interest on interest accrued for previous months. As an extension to the example above, if the lender is paying 8.5% interest to their investors and choose to compound interest monthly, they will have to pay $221,513.04 (per the full example principal balance and interest schedule) as total interest to their investors.

However, if the lender does not compound interest, the interest payable to the investors will be different and is calculated below:

\begin{align}\text{Formula} & = {\text{Amount Invested} \times \text{Interest Rate} \times \text{Number of Years} }\\& = {\text{\$1,200,000} \times \text{8.5%} \times \text{2}}\\& = {\text{\$204,000}}\end{align}

Interest in Advance

Interest in advance involves deducting the interest from the loan principal amount at the time of disbursement. The borrower receives a reduced amount (the principal minus the interest and any fees) but is obligated to repay the full principal over the loan term.

Interest in advance is different from prepaid interest as the borrower does not pay the interest from their own funds. Instead, the lender withholds the interest in advance when the loan is initially disbursed to the borrower. This method is often used in short-term loans and certain types of mortgages, where the interest for the upcoming period is deducted from the loan principal upfront.

How It Works

Initial Loan Disbursement: When a loan is taken out, the borrower receives the net principal amount (after all fees and interest in advance are deducted). The lender usually calculates interest on the principal amount, which includes all fees and interest in advance charged to the borrower at that point in time.

Upfront Interest in Advance: At the start of the loan period, the lender withholds the interest in advance from the loan principal, which is then used to service the interest accrued throughout the loan term. The interest in advance withheld can be for the full interest amount of the loan term or a portion of the loan term. For example, if the loan term is 12 months and interest in advance covers interest for only six months, then the expectation is that the borrower makes regular interest payments for the remaining of the loan term after the initial six months has passed.

Loan Term: Throughout the loan term, the borrower does not need to make additional interest payments, as the lender has already accounted for the interest from the loan principal. However, as mentioned above, should the interest in advance be for only part of the loan term, the borrower will have to make interest payments after that period has passed.

Example

A borrower takes out a $1,200,000 short-term loan on the 1 March 2020 with a two-year term and an interest rate of 8.5% p.a. The lender charges fees totalling $200,000 when the loan is disbursed. Instead of paying monthly interest or having the interest capitalised, the lender withholds interest in advance of $204,000 ($1,200,000 X 8.5% X 2), which covers interest for the full loan term of 2 years, when the loan is disbursed. The borrower receives $796,000 as the net principal amount from the lender and does not have to make any interest payments for the duration of the loan.

Benefits and Drawbacks

Benefits

• Simplifies budgeting, as interest costs are known and withheld upfront.

• May result in lower overall interest costs if the lender does not compound interest. In the example above, total interest charged to the borrower is $204,000, while total interest charged to the borrower if interest were capitalised is $221,513.04

Drawbacks:

• Requires a higher initial cash outlay, which can be burdensome for some borrowers.

• Limits the borrower's flexibility to manage cash flow.

Practical Applications

Interest in advance is advantageous for short-term borrowing needs such as bridging loans, personal loans or certain types of investment loans. For instance, a borrower needing a short-term loan to bridge the gap between purchasing a new property and selling an existing one might opt for an interest in advance loan. This approach provides clarity on interest costs and can simplify financial planning, especially when the investment timeline is clear and concise.

Lender Considerations

The loan principal of $1,200,000 needs be raised from investors, which is then split up between the fee to the lender ($200,000), interest in advance ($204,000) and net loan principal to the borrower ($796,000). The table below shows how funds are raised from investors, in this situation three different investors are willing to invest $550,000, $400,000 and $250,000, totalling to $1,200,000. As interest is now held for the term of the loan, it is up to the lender to decide when they will distribute the interest to their investors for their respective investments made. Some lenders prefer to pay out the interest to the investors throughout the loan term on a regular basis while others might pay the total interest at the end of the loan term.

Prepaid Interest

Prepaid interest refers to the interest paid by the borrower before the due date set out by the lender. The borrower can prepay interest for the full term of the loan or for part of it. This is commonly seen in mortgage investment loans where the borrower prepays interest for a year so that the prepaid interest can be classified as deductions for tax return purposes.

How It Works

Initial Loan Disbursement: When a loan is taken out, the borrower receives the net principal amount (after all fees are deducted). The lender will neither capitalise interest nor withhold interest in advance at the time of disbursing the loan as the borrower is expected to prepay interest.

Example

Consider a mortgage investment loan where the borrower takes out a $1,200,000 short-term loan on the 1 March 2020 with a two-year term and an interest rate of 8.5% p.a. To claim the interest prepaid for tax purposes, the borrower then proceeds to prepay interest up to 30 June 2021. The benefit of an immediate tax deduction may be quite appealing where taxable income is currently higher than what is expected in future years, for example, if there is an expected break from the workforce or change in employment.

The lender charges fees amounting to $200,000 when the loan is disbursed, effectively resulting in the net principal amount of $1,000,000 to the borrower. As the borrower prepays interest up to 30 June 2021, the borrower must pay the balance of interest (from 1 July 2021 to 28 February 2022) when required.

Benefits and Drawbacks

Benefits

• Prepaid interest ensures that the borrower only pays for the actual time they have access to the loan funds, aligning payments with the usage period.

• The borrower can reduce the tax bill if future income can be estimated accurately.

Drawbacks

• It can increase the upfront costs associated with obtaining a loan, which might strain the borrower's immediate finances.

• The timing and calculation of prepaid interest can be complex, requiring careful management to ensure accuracy and fairness.

Key Differences and Considerations

When comparing capitalised interest, interest in advance and prepaid interest, it is essential to consider the nature and duration of the project and financial position. Capitalised interest suits long-term projects where initial revenue is delayed, while interest in advance is ideal for short-term financing with immediate clarity on interest costs. On the other hand, prepaid interest is best suited if the borrower can estimate their marginal tax rates and have the resources to prepay the interest.

Borrowers must assess their cash flow capabilities, project timelines and financial strategies to determine the most appropriate interest payment structure. For investors, understanding these structures helps evaluate the security and profitability of their investments.

Conclusion

Capitalised interest, interest in advance and prepaid interest offer unique advantages and challenges, catering to different financial needs and scenarios. Understanding these concepts can aid borrowers in selecting the most appropriate financing structure for their specific situation, ultimately contributing to more effective financial management and planning. By carefully considering the implications of each approach, individuals and businesses can optimise their financial strategies, manage risks and achieve their project goals efficiently.

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