Crouching repayments, hidden interest: how interest capitalisation works

A home loan repayment pause may be an option for those experiencing financial difficulty, but it can help to be aware of how interest capitalisation could affect you before taking one.

With many home loan providers offering repayment pauses to some financially-affected customers during the COVID-19 pandemic, putting a hold on your home loan has become a necessity for some.

However, if you take a repayment pause, you could potentially be in for a shock at the end of it, as the size of your loan and regular repayments may have gone up. This would likely be due to interest capitalisation.

What is interest capitalisation?

Interest capitalisation occurs when interest is added to the total loan amount or ‘principal’ of a loan but isn’t immediately paid back on an ongoing basis by the borrower. Allowing interest to capitalise can be a necessity for some borrowers in the event of financial hardship in order to reduce the size of, or completely pause, your loan payments for a period of time. In addition, this approach can be built into some investment loan agreements from the start. For example, the Australian Taxation Office (ATO) notes that interest capitalisation can be utilised as part of some, “more complicated” investment loan repayment arrangements.

What’s the difference between a repayment pause and switching to interest-only repayments?

Whereas switching to interest-only payments involves not making payments towards the principal of your loan for a period of time but still paying off the regular interest charged on it, taking a repayment pause generally involves deferring your principal and interest repayments altogether for a set period of time, and then having the interest that you would have paid over that time added (capitalised) onto your loan, so your loan amount is higher at the end of that period.

How does interest capitalisation work?

Interest capitalisation works by allowing a principal-and-interest borrower to temporarily stop paying off the interest that is being added to their loan for a period of time. The home loan provider will then take this added interest into account when calculating interest on the new loan balance in the next period. This is known as compounding interest, or paying interest on existing interest.

It’s much the same as how compound interest on savings works, except you are being charged interest on your interest rather than earning it.

Here’s a hypothetical example: the table below displays the extra interest a six-month home loan holiday would add to a $350,000 home loan, as well as what you’d need to increase your monthly repayment to after the holiday in order to repay it within the same 30-year term.

Monthly repayment Adjusted repayment post-home loan holiday Total interest paid over the life of the loan
$350k loan, 30-year term $1,574 N/A $216,609
$350k loan, 30-year term, with a six-month repayment holiday $1,574 $1,618 $222,233
Extra interest paid as the result of the six-month repayment holiday $5,623
Source: www.canstar.com.au – 22/04/2020. Assumes interest is capitalised during the six-month repayment holiday that begins one year into the loan, for a principal and interest loan of $350,000. For the repayment adjusted scenario, the repayment is adjusted after the repayment holiday period to pay off the loan within the original loan term of 30 years. For the same repayment scenarios, the monthly repayment is unchanged from the scheduled repayment prior to the repayment holiday period. Based on an interest rate of 3.51% on a $350,000 loan at 80% LVR (excluding any lower introductory interest rate or first home buyer-only loans).

The increased loan principal size means that, in order to repay their loan within the same period of time as before, the borrower would need to increase their monthly repayments. If they don’t increase their monthly repayment, their home loan may require more than the agreed-upon term to repay, and you would potentially have to negotiate a new term with your home loan lender or refinance your home loan with a different lender.

If you’re experiencing financial stress, a repayment pause may be one of the ways in which you can relieve it, at least temporarily. However, you should be aware of interest capitalisation and how it works before you agree to a repayment pause, so you can make an informed decision about whether or not a repayment pause is right for you. It’s important to consider the long-term effects of capitalising interest into your loan, and whether you’ll be able to deal with them potentially larger repayments after the pause has ended. If you’re looking to reduce the size of your home loan repayments, a lower interest rate could also help, if you are in a position to negotiate with your lender or to switch to a new one. You can compare home loans and potentially find a better rate with Canstar.

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