If you have a mortgage or another big loan, a repayment holiday probably sounds pretty appealing. It has the word 'holiday' in it after all - how can you say no to that?

However, while deferring your home loan repayments could be a good financial choice if you find yourself in strife, you need to balance the benefits against the consequences.

It's important to understand what capitalised interest is and how it could affect you before you go ahead.

What is capitalised interest?

If you have an outstanding loan, you'll probably always be charged interest. Even if you pause your repayments, or have them temporarily reduced to just the principal portion, interest will continue to accrue.

Capitalised interest refers to the interest that has accrued on a loan which isn't paid.

When you don't pay back that interest straight away, it is 'capitalised' - added to the outstanding principal amount you owe. You're, therefore, charged interest on this interest.

If it helps, you can think about capitalised interest the way you might think about compound interest on a savings account, whereby you earn interest on interest previously earned. Capitalised interest works in the other direction.

Calculating capitalised interest

Let's say you have a $500,000 home loan with 25 years remaining and a fixed interest rate of 6.00% p.a.

Per Your Mortgage's home loan repayment calculator, you'd be paying roughly $3,221.51 per month in repayments.

Now imagine you're experiencing mortgage stress and your lender agrees to grant you a six-month repayment holiday.

For those six months, you mightn't pay anything back, but the $550,000 you owe will continue to accrue interest.

At 6.00% p.a, that means $15,000 in total interest over those six months. This interest might then be 'capitalised' and added to your outstanding principal.

When you go back to paying off the loan, you'll owe $515,000. Your monthly repayments could therefore grow to about $3,318.

Can you avoid capitalised interest?

If you aren't paying the total amount of interest you owe on your home loan, it will generally be capitalised. Lenders aren't a charity after all, and interest is the cost of borrowing money, so it will continue to be charged while you have an outstanding mortgage.

If you defer your interest payments, you're also effectively borrowing the cost of interest on top of the principal.

Interest capitalisation is generally an unavoidable consequence of deferring your interest payments by, for example, taking a repayment holiday. If you're struggling with your loan repayments and want some relief without interest capitalising, there are a couple of alternatives:

  • Switching to an interest only loan: A way to temporarily reduce your home loan repayments is to switch to interest only repayments. This means you'll only paying the interest you accrue, rather than repaying the principal balance. That way, you avoid interest capitalisation, since you'll continue to pay interest as it's charged. However, you'll likely still pay more in interest in the long run, since you'll be paying off your home loan for longer.

  • Refinancing to a lower rate: If you haven't shopped around for alternative home loan products before exploring repayment holidays, it's highly advisable that you do so. From non-bank lenders to credit unions, there're a huge range of mortgages and mortgage providers out there, and switching to a lower rate might relieve some of the pressure you're experiencing.

  • Cut down on discretionary spending: Interest capitalisation means you shouldn't see a repayment holiday as a Get Out of Jail Free card. It's an option to consider once you've exhausted less expensive alternatives. For example, if you've already slashed your non-essential spending. If you can go through your budget and identify several areas on which you could cut back, it's worth doing. You might find doing so alleviates your mortgage stress without you needing to consider deferring your repayments.

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