Capitalization of interest is adding accrued interest to the principal balance, so that the interest-bearing principal balance of the loan increases. true or false?

General
1

capitalization of interest is adding accrued interest to the principal balance, so that the interest-bearing principal balance of the loan increases. true or false?

2

LectureNotes said capitalization of interest is adding accrued interest to the principal balance, so that the interest-bearing principal balance of the loan increases. true or false?

Answer:
The statement provided by LectureNotes is true. Capitalization of interest indeed refers to the process where accrued interest is added to the principal balance of a loan. This process results in an increase in the interest-bearing principal balance of the loan.

Explanation:

  1. Accrued Interest:

    • Accrued interest is the amount of interest that has accumulated on a loan but has not yet been paid by the borrower. It is typically calculated on a daily basis.

  2. Adding Accrued Interest to Principal:

    • When accrued interest is capitalized, it is added to the loan’s outstanding principal balance. For instance, if you have a loan with an accrued interest amount of $500 and a principal balance of $10,000, after capitalization, the principal balance becomes $10,500.

  3. Increased Interest-Bearing Principal:

    • Since the accrued interest is now part of the principal balance, future interest calculations will be based on this new, higher principal amount. Consequently, the borrower will end up paying interest on a larger principal.

Example:

Suppose you have a loan with the following characteristics:

  • Original principal: $10,000
  • Annual interest rate: 5%
  • Interest accrual: $500

Before capitalization:

  • Principal = $10,000
  • Accrued Interest = $500

After capitalization:

  • New Principal = $10,000 + $500 = $10,500

In the next period, if the interest rate is applied, it will be calculated on $10,500 instead of $10,000, resulting in a higher interest amount.

Summary:

Capitalizing interest is a common practice in various types of loans, including student loans, mortgages, and some business loans. While it can be helpful in deferring payments, it leads to the compounding of interest, making the total repayment amount larger over time.

Conclusion:

The statement by LectureNotes is true: Capitalization of interest involves adding the accrued interest to the principal balance, thus increasing the interest-bearing principal balance of the loan.