How to Calculate Capitalized Interest on Construction Projects Step by Step Instructions And Examples
Borrowing funds to complete buildings that will be fixed assets for your company is often necessary. Capitalized interest on these types of loans can be beneficial to construction companies.
But if understanding capitalized interest in construction seems complicated, calculating capitalized interest may seem completely over your head — especially if you’re not a “numbers” person.
In this article, we’ll:
- Explain what capitalized interest in construction is
- Outline steps on how to calculate capitalized interest; and
- Include a few capital interest examples for clarity
- And more
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What Is Capitalized Interest?
Suppose your growing construction company now needs its own headquarters. The most economical way to make that happen is to construct the building yourself. But you’ll need a loan to finance this grand endeavor — and loans always come with interest charges.
This is where capitalized interest comes in.
Capitalized interest is the finance costs (interest) necessary to construct a long-term asset (like a headquarters building). These finance costs — the interest accrued during the building process — are added to the value of fixed assets on the company’s balance sheet. The capital interest appears on the income statement in installments through periodic depreciation expense on the asset over its useful life.
In simple terms, capitalized interest allows you to count those interest costs as an asset rather than being charged off as an expense.
Is Interest Capitalized During Construction?
Interest can be capitalized on a construction structure that is intended to be a long-term asset. As discussed above, the interest accrued during the project is not a deductible expense but is added to the value of the asset instead.
The following project costs should be included in capitalized interest:
- Construction of a long-term asset
- Costs of professional fees of architects and engineers
- Permits
What Is the Purpose of Capitalized Interest in Construction?
Rather than expensing interest on the debt that accompanies the construction of long-term assets, capitalizing interest on these types of assets allows companies to include it on their balance sheets as part of the historical cost.
This type of accounting is outlined in the Generally Accepted and Accounting Principles and will benefit a company for many years over the useful life of the construction.
How to Calculate Capital Interest
To calculate capitalized interest, follow these straightforward steps:
- Multiply the average amount of the loan during the time it takes to complete the building of the asset by the interest rate and the development time in years.
- Subtract any investment income that pertains to the interim investment of the borrowed funds.
For example, let’s say a company borrows $1 million to build an office building that will take one year to finish. Therefore, the borrowing cost pertaining to the project during the interim period is $100,000 or 10% of the borrowed amount.
The interest is capitalized by adding it to the borrowed amount, which will increase the cost basis to $1,100,00 ($1,000,000 + $100,000 = $1,100,000).
Calculating Capitalized Interest in Construction in 4 Easy Steps
Step 1: Pinpoint the Capitalization Time
The first thing to do is to determine the time period between when the construction of the fixed asset begins and when it is ready to be used.
The capitalization of borrowed funds ends when the asset is ready for its intended use or is substantially completed. The capitalization time period is not extended for minor modifications. If part of the building is ready to use before other parts are completed, the capitalization should be discontinued on the phase that is completed.
Step 2: Determine Weighted Average Accumulated Expenditure
If an asset is obtained in the middle of the year, you will use a weighted average and only capitalize the interest on the portion of the year that you own the asset.
To figure weighted average accumulated expenditure, simply multiply the expenditure by the number of months in capitalization.
For example, if you purchase an asset in April, you will incur interest payment for only 9 months out of the year.
Step 3: Calculate the Interest
Calculate the following types of interest:
- Interest in specific borrowings and general fund
- Avoidable interest
- Actual interest on loans
Below, we will share how to calculate these types of interest.
How to Calculate Interest in Specific Borrowings and General Fund
For construction projects of fixed assets, calculate specific borrowings by subtracting any investment income earned during the interim investment from the actual borrowing cost.
For general fund needs, figure an interest rate from the weighted average of the borrowing costs.
How to Calculate Avoidable Interest
Here’s how to calculate avoidable interest:
Avoidable interest equation: Multiply the weighted average accumulated expenditures by the proper interest rate.
How to Calculate Actual Interest on Loans
To calculate actual interest on loans, simply multiply the interest rate by the amount of the loan.
Step 4: Finalize Determination of Capitalized Interest
After completing these calculations, choose the lower of the two — either the avoidable interest or the actual interest.
3 Capitalized Interest Examples
Numbers and formulas can be confusing, so let’s clear things up with a few examples.
#1: Capitalized Interest on a Single Amount
Allied Construction Company borrows $200,000 at a 5% interest rate to construct an addition to their headquarters building. After one year, the construction is complete.
The cost will include the original amount ($200,000) plus the interest expense ($10,000) equaling $210,000.
#2: Capitalized Interest on Multiple Amounts
To accommodate their worldwide enterprise, Allied Construction International is building a new headquarters.
On January 1, the company made a payment of $25,000,000 and on July 1, they made another payment of an additional $40,000,000. The construction was completed on December 31.
The company can capitalize the entire $25,000,000 of the first payment, but only half of the $40,000,000 because that payment was made with only 6 months remaining in the capitalization time period. Thus, the total amount for capitalization is $45,000,000 ($25,000,000 + $20,000,000).
During this time period, the company pays 7.5% interest on the outstanding loan. The capitalized interest amount is $3,375,000 ($45,000,000 x 7.5% interest).
#3: 4-Step Capitalizations
The Allied Construction Company is constructing a building to house their production efforts. Construction begins January 1 and ends December 31.
The following loan amounts are outstanding beginning January 1:
- $50,000 at 10% interest (for specifically constructing the building)
- $65,000 at 8% interest (for a general loan)
The following payments were made for the building’s construction:
- February 1 - $40,000
- August 1 - $65,000
To figure the capitalized interest, the company followed these steps.
- Determine the capitalization time frame:
The capitalization period would be from January 1 to December 31. - Determine the weighted average accumulated expenditure (WAAE):
WAAE = [$40,000 x (11/12)] + [$65,000 x (5/12)]
WAAE = $36,667 +$27,083 = $63,750 - Calculate the interest (specific borrowings, general funds, avoidable interest, and actual interest):
- Specific borrowings - $50,000 at 10% interest
- General fund - $65,000 at 8% interest
- Avoidable interest - ($50,000 x 10%) +[($63,750 - $50,000) x 8%] = ($5000) + ($1100) = $6100
- Actual interest - ($50,000 x 10%) + ($65,000 x 8%) = $5,000 + $5,200 = $10,200
- Final determination of capitalized interest:
Avoidable interest = $6,100 compared to Actual interest = $10,200
The lower of the two is the avoidable interest of $6,100 which becomes the capitalized interest.
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