What is capitalised interest on a mortgage?

Financial distress is never easy to deal with for anyone. If you’ve lost your job or are facing a pay cut, you would rightly be worried about how you might pay your outstanding debts, such as a home loan or a car loan. Most Australian lenders offer borrowers a repayment pause, giving them a break lasting up to six months from making any payments whatsoever. However, in most cases, this is not unconditional relief, and your loan is still accumulating interest. You’re likely to find that the interest on your home loan has been capitalised during the pause, increasing the total loan amount you have to repay. 

What happens if you capitalise the interest on your home loan?

A home loan is a long term debt that you repay over a period that can range from 10 to 30 years. During this time, you’re likely to go through many life changes and face unexpected situations. If these changes make it difficult for you to continue your home loan repayments, you should discuss it with your lender. You may be able to request your lender make certain hardship variations during these times. 

These variations can include being able to request either a revision of the home loan terms or of the expected repayments. They also include reducing your repayments by switching to interest-only for a short duration rather than principal and interest. Another option is a repayment pause, or deferral, which allows you to take a break from making any payments for a set period negotiated by you and your lender. However, a deferral or pause doesn’t stop the interest on your home loan from accruing. The interest just gets capitalised or added to the principal of your loan. Once you restart payments, interest will be calculated based on this larger sum, therefore increasing the total cost you pay on your home loan.

As a borrower, you have to repay the borrowed amount and any interest accrued on your loan, and you have limited room for negotiation once you’ve accepted the loan. You should always discuss your financial situation with your lender before making any changes such as a pause. You can also consider putting small amounts into your loan even when you have repayments paused to help minimise the impact. Make sure to discuss this with your lender as well because you may incur fees or they may see these payments as meaning you’re able to begin repayments again. If you have an offset account, you could put funds into it and transfer them to your loan once the pause is over. The money in this account will also work to lower the interest you accrue.  

How can I prevent the capitalisation of my home loan interest?

If you find yourself in a situation where you’ll miss a home loan repayment, you should discuss it with your lender immediately. Not doing so may lead to the lender reporting a payment delay or default against you, which can bring down your credit score. The lender may then appoint a hardship officer to review your case and suggest an alternative repayment plan. Your lender may offer you a repayment pause which then means any interest will then capitalise into the principal of your home loan. 

To avoid capitalisation of your home loan interest, you can instead discuss a short-term plan for lowering the size of your repayments. For instance, if your current repayments are $1,000 a month, you could request reducing this to $500 or $700, based on what you can afford. You may also need to specify the duration you wish for this lowered repayment to be in place. You should remember that lowering your repayments is like a partial deferral, and will result in a small increase in the total amount you need to repay to the lender. 

Another option lenders offer to help you lower your repayments without capitalising your interest, is switching to an interest-only repayment plan. Typically you repay part of the principal or loan amount and part of the interest accrued on the principal in your repayments. You can ask your lender if you can temporarily pay only the interest on the loan. Doing this will bring down the repayment amount, and it won’t capitalise the interest. You’ll need to work out these arrangements with your lender, and there will likely be a strict timeline for how long you’re able to be on interest-only repayments.

You can also consider reviewing your budget while making these lesser repayments. There may be expenses that you can put off without incurring additional debt. Or you may choose to wait to use your holiday savings and instead divert them into making home loan repayments. Consider checking if you can split your utility payments into two or more instalments so that you can save up a bit for paying the full utility bill. 

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