What is interest capitalisation?
Capitalised interest is interest that’s added onto a home loan’s outstanding balance (the principal), but not immediately paid back. It usually happens when borrowers reduce or pause their loan repayments for a period, typically because they’re struggling financially.
Interest capitalisation can also be a routine part of bridging loans (which can help a person buy a new home before selling their old one) and reverse mortgages (which can help older Australians access their home equity).
What’s the difference between an interest-only period and a repayment pause?
An interest-only period on a home loan means you only repay interest as it accumulates, reducing none of the principal.
Pausing your repayments typically means paying neither, and having the interest you accrue added (capitalised) onto the principal.
How does interest capitalisation work?
When it comes to a repayment pause, interest capitalisation allows you to temporarily stop paying back your home loan. The amount you have outstanding continues to earn interest, which in turn is added to what you owe.
Importantly, capitalised interest compounds. That means it’s added to the amount your interest bill is calculated on and you will accrue more interest on previously charged interest.
If you take a repayment reduction or break, you’ll generally end up paying more in interest than you otherwise would have.
Capitalised interest in practice
Here’s an example of how interest capitalisation can work. Say you owe $600,000 at 6% p.a. with a 30 year loan term.
Your principal and interest repayments (P&I) could be around $3,866 per month (according to Canstar’s mortgage repayment calculator).
Now imagine you take a three month repayment holiday. You’ll still accrue interest on your $600,000 principal balance over that time, which (assuming interest compounds monthly) adds up to about $9,045.
Your resumed P&I repayments may therefore increase, up to around $3,940 each month, because of the larger balance.
Is pausing your home loan repayments worth it?
Pausing your home loan repayments generally doesn’t mean your lender will let you off on anything.
The amount you don’t pay now, you’ll probably have to pay later. Capitalised and compounding interest means, once you resume paying, you’ll probably have to increase either your repayments or your loan term. A repayment pause may also appear on your credit report, although it mightn’t necessarily affect your score.
A repayment pause is generally a last resort if you’re in financial stress. If you’re struggling with your home loan, your lender is legally required to offer hardship assistance.
Pausing or temporarily lowering your repayments might be one of the options its hardship team recommends, along with alternatives like switching to interest-only repayments or having fees waived. Often the sooner you reach out for help the better off you’ll be.
If you’re not at that point yet, but looking to save on your home loan repayments, a lower interest rate may do the trick. You can compare home loans with Canstar to see if you can find a better rate. You can then either use the knowledge to negotiate with your lender or refinance to a new one offering a better deal.
