Capitalized interest has to do with the interest that is associated with just about every type of loan agreement. Basically, it can be understood in terms of expensed interest that occurs when the regularly scheduled loan payments are not made on time. In many types of loans, the unpaid interest that is part of the delinquent payment is added to the principal balance of the loan.
This type of interested does not necessarily only occur when payments are late or are missed, however. It can also be amortized in situations where payments are deferred for some reason. For example, if the borrower works with the lender to suspend payments for a short period of time, this is known as forbearance. During this arranged time, payments are not considered to be delinquent. At the same time, the portion of those deferred payments that would have gone toward the accrued interest on the loan will be added back to the principal, creating capitalized interest.
There are actually some situations in which this action may be in the best interests of the borrower. This is especially true if the purpose of the loan was to create an asset that will be capable of generating revenue once it is completed, such as to finance the construction of a building. Seeking a deferred payment arrangement does create more interest and higher payments down the road, but it also frees resources to be devoted to the project. Once the building is complete and can begin generating revenue, the additional cash flow will offset both the higher loan payments and the extra interest.
In some cases, a lender may be not be agreeable to a deferred payment schedule, but will be open to receiving only payments on the loan interest for a period of time. In this scenario, the borrower may choose to use part of the loan proceeds to make the payments on the capitalized interest. This allows the borrower to buy some time until the project is completed and the assets begin to generate revenue to cover both the loan principal and the interest.