The three ways interest gets handled
Serviced monthly: the borrower pays interest each month from cash flow. Prepaid or retained: interest for the whole term is deducted from the advance at settlement and held, so the borrower receives less cash but owes nothing monthly. Capitalised: interest accrues and is added to the balance, repaid in full at the exit.
Capitalising suits borrowers with no spare cash flow during the term — a developer before settlements, or an owner waiting on a sale.
The effect on LVR and loan size
Because the balance grows, lenders size against the end-of-term position. A $2,000,000 facility at 10% for twelve months with capitalised interest and a 2% fee finishes near $2,240,000. Against a $3,000,000 valuation that is a 75% exit LVR from a 67% day-one LVR.
This is why you may be offered less than you expected: the lender is protecting the exit LVR, not the opening one.
Choosing between the options
Capitalise when you have no interim cash flow and need the maximum breathing room. Service monthly when you have income and want the smallest total cost and the largest available advance. Prepay when the lender requires certainty of interest and you can accept a reduced net advance.
Also check whether interest is calculated on the drawn balance or the full facility limit — on a progressively drawn construction loan that difference is significant.
Key points
- Capitalised interest is added to the balance, not paid monthly.
- It grows the balance, so lenders size against the exit LVR.
- Serviced interest usually gives the lowest total cost and largest advance.
- Confirm whether interest accrues on drawn funds or the full limit.
Frequently asked questions
Do I pay interest on capitalised interest?
Usually yes — once capitalised, it forms part of the balance on which interest accrues. Check the loan documents.
Is unused prepaid interest refunded on early repayment?
Sometimes, sometimes subject to a minimum interest period. Ask before signing.
Does capitalising reduce how much I can borrow?
Effectively yes, because the lender must keep the end-of-term LVR within tolerance.