Financial Dictionary - Capitalisation of interest
Capitalisation of interest
Capitalisation allows us to understand how capital changes over a given time frame. This will vary depending on whether it is simple or compound. In simple capitalisation, the interest generated by the principal will not be added to this amount to calculate future payback. That is, these will always be calculated based upon the original principal. This formula is used above all when we are paying the interest portion of our mortgage (or in general, on any loan that is in default status: when we only pay interest.) On the other hand, compound capitalisation includes the interest generated by that capital over time (it is not usually applicable for the calculation of mortgage loans, but rather in funds where the interest is received by the investor). And it will also be on-going in the sense that as the interest accumulates, it will mean continuous reinvestment of interest and more generation of capital to be repaid.
When dealing with the capitalisation of interest, it must be noted that if the credit institution makes a judicial claim for non-payment of the monthly payments, the special interest will begin to accrue from the moment that the claim is filed. In any case, when signing a mortgage, it is always advisable to check whether this capitalisation is included in the conditions, since if it is not, it cannot be charged.
Late payment interest and accrued interest
It is important to understand the difference. In the case of a mortgage, late payment interest is generated when we do not pay our monthly payments; we can say it is a penalty for non-payment. Instead, accrued interest is the normal interest that we pay to the bank for lending us the money.
Late payment interest will increase the capital that the bank has provided us, and generates interest on interest. This would be considered usury, and is prohibited by the Mortgage Law as an abusive clause.
What the law does allow, when there is a provision for the capitalisation of interest, is the adding of the accrued and unpaid interest to the outstanding principal; this is something which is completely legal.
The capitalisation of interest and compound interest
Capitalization of interest should not be confused with compound interest. Compound interest occurs when, in addition to accrued interest, interest arising from the delay is added to the principal borrowed, which is applied as a penalty for non-payment. In other words, would mean charging interest on interest. Compound interest on mortgage loans generates a significant increase in the total amount to be repaid and is considered an abusive bank clause, which is prohibited by law.