Businesses sometimes undertake projects to acquire long-term assets which take significant time to complete. When debt is used to finance such projects, interest begins to accrue as soon as the lender disburses funds, adding to the overall cost of the project. For accounting purposes, this type of borrowing requires capitalization of interest, as do student loans. When student loan payments are deferred, accrued interest may be capitalized, which can be computer with a capitalized interest calculator. However, students should know how the calculation works so they fully understand their loan obligations.
When a company or other organization acquires a long-term asset such as a new production facility, the cost of borrowing during the period from project inception until the asset is ready for use may be treated as part of the capital investment under generally accepted accounting principles. That is, interest on funds borrowed for the project are added to the cost basis of the asset. The cost of borrowing incurred during the construction period appears on the firm's balance sheet, rather than as an expense on the income statement. This capitalized interest will show up on the income statement as a depreciation expense in future years.
Here is an example of a borrowing cost problem and solution involving capitalized interest. Suppose a business decides to build a new production plant and borrows $10 million for this purpose. It will take one year before the plant is ready for use. The borrowing cost attributable to the project during this interim period will be $1 million. This interest is capitalized by adding it to the borrowed $10 million, which increases the cost basis to $11 million. If the useful life of the facility is 40 years, based on straight-line depreciation, the yearly depreciation amount in this capitalized interest example is $275,000.
You can use a capitalized interest calculator, but the formula for figuring interest capitalization is straightforward. Multiply the average amount borrowed during the time it takes to acquire the asset by the interest rate and the development time in years. Subtract any investment income attributable to the interim investment of borrowed funds. Suppose a firm borrows $10 million for a real estate development that will take one year to complete. Six months into the project, the company borrows another $10 million. The average balance is $10 million plus half of the second $10 million or $15 million. The interest rate is 10 percent; therefore interest is $1.5 million. The borrowed funds are kept in an interest-bearing account until needed and generate $100,000 in interest. This reduces the borrowing cost to $1.4 million, which is capitalized by adding it to the $20 million in borrowed funds. The cost basis for the project works out to $21.4 million.
When someone takes out student loans to finance a college education, he or she is likely to encounter borrowing cost problems and solutions that include interest capitalization. Student loan capitalized interest calculator tools are available. However, the computation is not complicated. As a capitalized interest example, suppose the student attends graduate school and borrows $2,500 each semester for two years with a 4-percent annual interest rate. The principal amount will total $10,000. Repayment is deferred until six months after the student leaves school, but interest begins to accrue starting when each loan amount is disbursed. In this example, interest will accrue for 10 quarters for the first $2,500 disbursement and eight, six and four quarters for successive amounts. The total accrued interest comes to $700. If the student chooses not to pay the interest as it is incurred, $700 is added to the balance of the loan at the time repayment begins. The principal balance of the loan is increased to $10,700.