Capitalized Interest vs. Accrued Interest

While both accrued interest and capitalized interest relate to the cost of borrowing, they represent different stages with distinct accounting and financial consequences. Accrued interest is a continuous process of recognizing interest expense as it is incurred over time. Capitalized interest is a specific event where that accumulated interest is added to the original loan amount.

Understanding Accrued Interest

Accrued interest is the amount of interest that has been incurred but has not yet been paid. It accumulates on a daily basis between payment dates. For individuals, a common example is the interest that builds up on a credit card balance after a purchase and before the statement closing date. Similarly, for many student loans, interest begins to accrue daily from the moment the loan is disbursed, even if payments are not yet due.

In a business context, this concept is an application of the accrual principle of accounting, which requires expenses to be recognized when they are incurred, not necessarily when cash is exchanged. When a company has a loan, it records the interest cost as it builds up each day. This is reflected on the income statement as an interest expense, which reduces the company’s reported profitability for the period.

A corresponding entry is made on the balance sheet. The amount of interest that has been expensed but not yet paid is recorded as a current liability, often in an account called “Interest Payable.” When the scheduled interest payment is made, the company’s cash balance decreases, and the Interest Payable account is reduced by the same amount.

Understanding Capitalized Interest

Capitalized interest is the process of adding unpaid, accrued interest to the principal balance of a loan or the cost of an asset. Instead of being treated as a periodic expense on the income statement, the interest cost is reclassified and added to a long-term asset or loan balance on the balance sheet.

For businesses, accounting standards permit interest to be capitalized as part of the cost of acquiring or constructing a “qualifying asset.” Qualifying assets are those that require a significant period of time to get ready for their intended use, such as a building a company is constructing for its own operations or a large piece of machinery being custom-built.

The capitalization period begins when three conditions are met: expenditures for the asset have been made, activities to prepare the asset are in progress, and interest cost is being incurred. Once the asset is substantially complete and ready for its intended use, interest capitalization must stop. From that point forward, any further interest on the related debt is treated as a regular expense on the income statement. The capitalized interest is then depreciated over the asset’s useful life, along with the rest of its cost.

For individuals, capitalized interest is most frequently encountered with student loans. However, recent regulatory changes have eliminated most instances of interest capitalization on federal Direct Loans. For many borrowers, particularly those on income-driven plans like SAVE (Saving on a Valuable Education), any unpaid interest that accrues may be waived rather than capitalized. Capitalization on federal loans is now largely restricted to a few specific situations, such as when a borrower leaves the Income-Based Repayment (IBR) plan. The practice remains more common for private student loans.

Key Distinctions and Financial Impact

The primary distinction between the two concepts lies in their treatment on financial statements and timing. Accrued interest is recognized as an expense on the income statement, reducing net income. Capitalized interest is added to the value of an asset on the balance sheet, so it does not immediately impact profitability. Accrual is a constant process, while capitalization is a one-time event that happens only when specific criteria are met.

The financial impact on a borrower can be substantial when capitalization occurs. To illustrate how it works, consider a student with a $10,000 loan at a 6.8% interest rate where capitalization applies, such as with certain private loans. During a six-month grace period after graduation, the loan would accrue approximately $340 in interest. If this interest is not paid, it will be capitalized when repayment begins, making the new principal balance $10,340.

From that point forward, the daily interest calculation is based on this higher principal amount. The new daily interest would be slightly higher, and over the life of a standard 10-year repayment plan, this small change can lead to hundreds of additional dollars paid. An actionable step for borrowers is to pay the accrued interest before it capitalizes. By paying the $340 before the repayment period starts, the principal remains at the original $10,000, keeping future interest charges and the total cost of the loan lower.