Capitalised Interest – How the Wrong Calculations May Be Smashing Your Profits
As a property developer, cashflow is often paramount, so it is common to hold loans with capitalised interest so that the requirement to service on an ongoing basis is removed. For construction loans, capitalised interest facilities are generally a must, but many developers also use them for land and residual stock transactions. This article deals with the nuances of capitalised interest and how to make sure you are comparing apples to apples when assessing various lender options.
Capitalised interest occurs when the interest on a loan is added to the principal balance, increasing the total amount of the loan. This interest is then subject to future interest charges, compounding the cost of borrowing. In other words, you are paying interest on the already accrued interest. Servicing the interest monthly or quarterly may be a valid cost-saving strategy to avoid paying extra interest. However, for many developers, this puts them under undue cashflow pressure, and it is better to have the interest capitalised despite the additional cost. However, lenders use different ways of calculating interest, which may mean calculating the overall cost is more complex than taking the cheapest interest rate.
Take the example of a borrower who is borrowing $1m for a residual stock transaction and has two offers, one from Lender A and one from Lender B.
Lender A has an interest rate of 9.5%, with interest capitalised for 12 months. With an interest reserve included in the figure. Effectively the total loan limit is fully drawn at settlement as the interest reserve is included in the loan balance, so the 9.5% is being charged on the total amount adds up to $95k in interest for the year.
Lender B has an interest rate of 10%, but the interest capitalises during the term, and the interest is charged only on the loan balance, so if $905k is the loan balance at settlement, the first month's interest is only charged on $905k with the second month being charged $905k plus the first-month interest capitalisation and so on. Using the compounding interest calculator, the actual interest charged to the borrower will be slightly less than the $95k charged for lender A with $94,788 in interest for the 12 months. Effectively Lender B is cheaper than Lender A despite a full 1% difference in interest rate.
How do you limit the effect of compounding interest on the profits in your project? Here are a few strategies to consider:
Negotiate a non-capitalising interest loan: Some lenders offer non-capitalising interest loans for land and residual stock, which means that payments are made either monthly or quarterly, and so interest does not compound. You need to make sure you are able to service a loan on an ongoing basis if you choose this option, and you may need to provide financials to evidence your ability to service.
Where capitalising interest is necessary, compare offers based on cost rather than just rate: This will involve making some detailed calculations about the actual likely cost of a facility rather than just looking at the interest rate and fees.
Reduce the Loan Term: By reducing the loan term, the interest reserve requirement and capitalised interest will reduce and therefore, the compounded interest payments will be less. This should be balanced with a well-thought-out exit strategy as there is no point in reducing cost in the short term, only to present a problem where you are required to repay the loan earlier than you are capable of.
Negotiate a lower interest rate: The lower the interest rate on your loan, the less impact capitalised interest will have on the total cost of borrowing.
Accelerate payments: Making extra payments or paying off the loan early can reduce the impact of capitalised interest.
For property developers, it is often necessary to use capitalised interest facilities, but understanding how interest is calculated in your facility will put you in a better position to choose the right option for funding your project and minimise the impact that compounding interest will have on your profits.