So, you're looking into secured business loans secured by property and hear the term "capitalising interest." Sounds a bit scary, right? Don't let the jargon scare you!
In simple terms, it means you're not making any loan repayments for a set period (usually the first three to six months), but the interest and any applicable fees for that time don't just disappear. Think of it like a tab at a restaurant: you don't pay for your drinks as you go, but at the end of the night, everything is added up, and you pay the total. With loan capitalisation, your tab is closed after six months and instead of paying it then and there, you then begin making repayments on that bigger balance.
How does interest capitalisation actually work?
Imagine you take out a business loan with a first or second mortgage on your property. The agreement includes a six-month interest capitalisation period. For those first six months, you don't make any payments. Sounds great, right?
But here's the catch: at the end of that six months, the interest that would have accrued is calculated and added to your original loan amount along with any of the up front fees. So, your new, bigger loan balance is what you start paying interest on, and start making repayments on. Or you have the option of refinancing the loan elsewhere and paying off the new loan balance in full (original amount borrowed, fees and six months’ worth of interest).
Why would a business want to capitalise a loan?
Now, you might be thinking, "Why would anyone want a bigger loan?" Well, there are actually some pretty valid reasons:
Cash flow cushion: This is the big one. For new businesses, those first few months can be tight. Capitalising interest frees up crucial cash to invest in getting off the ground – think marketing, inventory, and those essential first hires. It's like having a financial safety net when you need it most.
Navigating the ups and downs: Businesses with seasonal income, like tourism operators, might borrow money during the low season to carry out repairs and maintenance, and pay staff holidays. Capitalising interest helps them manage their cash flow when revenue is low and then start repaying when the busy season kicks in and the money's rolling in again.
Big projects, big spends: If you're investing in a major expansion, like building a new factory or buying a massive piece of equipment, capitalising interest can give you breathing room. You can focus your funds on the project itself and start repayments once the new asset is up and running and generating income.
Weathering a storm: Sometimes, unexpected economic hiccups happen. Capitalising interest can offer a temporary reprieve, allowing your business to ride out a short-term downturn without the added pressure of loan payments. It can be a lifeline to keep things afloat until the economy bounces back.
Strategic moves: Businesses waiting for a big payout, like the sale of an asset or payment on a large contract, might opt for this. It lets them cover immediate costs without having to scramble for funds, knowing a significant cash injection is on its way.
Growth mode: If you're anticipating a surge in business, you might capitalise interest to invest heavily now – hiring more staff, boosting marketing, increasing stock – to take full advantage of the upcoming boom. You're betting that future profits will easily cover the slightly larger loan.
Smooth transitions: Businesses undergoing big changes, like shifting their business model or expanding into new markets, can face temporary revenue dips. Capitalising interest provides a financial buffer to navigate these transitions without immediate repayment pressure.
Debt makeovers: When consolidating multiple debts, having a period of capitalised interest can simplify the initial stages of your new financial structure, giving you time to get everything sorted before repayments begin.
Supply chain survival: Facing a temporary disruption in your supply chain can seriously impact sales. Capitalising interest offers a bit of breathing room to find alternative solutions and keep your business going until things get back on track.
But it's not all sunshine and rainbows: the downsides of interest capitalisation
While capitalising interest on your business loan can be helpful, it's not a magic bullet. Here are the potential pitfalls:
Bigger loan, bigger repayments (eventually): This is the most obvious one. By adding the interest to your principal, you end up borrowing more money overall. This means your future repayments will likely be higher, and you'll pay more interest over the life of the loan.
Extending the debt: Capitalising interest essentially pushes your repayment start date further down the line. This means you'll be in debt for a longer period.
The interest snowball: Because the capitalised interest starts accruing interest itself, your business’s debt can grow faster than it would with regular payments. It's like interest on interest – a snowball effect that can make the total cost of the loan significantly higher.
Not a long-term fix: This is crucial. Capitalising interest is a short-term solution for specific situations. If your underlying business isn't healthy or your cash flow issues are chronic, simply delaying payments won't solve the bigger problem. It can actually make things worse in the long run.
Approval isn't guaranteed: Most lenders will assess your situation carefully before agreeing to capitalise interest. They need to be confident that your business has a solid plan to improve its cash flow and handle the larger future repayments.
The bottom line
Capitalising interest on a business loan can be a valuable tool in specific circumstances, providing crucial cash flow relief when you need it most. However, it's essential to understand the long-term implications. You'll end up paying more interest overall, and it's not a substitute for a sound business strategy. So, weigh the pros and cons carefully and seek independent advice to see if it's the right move for your business's unique situation.
If you’ve got equity in your property and the bank won’t release it, talk to us about a second mortgage with capitalised interest.