Interest capitalization

Interest capitalization means paying interest by borrowing more from the same credit account. Your lender effectively lends you the money to cover the interest charge, then adds that amount to your principal balance. No external cash changes hands.

This is common in Smith Manoeuvre strategies, where the goal is to keep cash invested rather than using it to pay interest.

How character is inherited

When you capitalize interest, the new principal takes on the character of the interest it paid:

• Deductible interest paid by capitalization becomes capitalized deductible principal — and interest charged on it is itself deductible
• Non-deductible interest paid by capitalization becomes capitalized non-deductible principal — and interest on it remains non-deductible

If you have a mix of outstanding deductible and non-deductible interest, capitalization is applied proportionally — just like credit payments.

Worked example

You have $150 in outstanding interest: $120 eligible (deductible), $30 non-eligible. You capitalize the full amount.

• Outstanding eligible interest: $120 → $0 (paid)
• Outstanding non-eligible interest: $30 → $0 (paid)
• Capitalized deductible interest: +$120 (new principal)
• Non-deductible principal: +$30 (capitalized non-deductible interest)
• Total debt: unchanged ($150 of interest became $150 of principal)

For tax purposes, you paid $120 of deductible interest — even though no cash left your pocket. That $120 counts toward your deductible interest for the year.

Here's how this looks in the app's event detail view:

Why capitalize?

Cash flow management: Keep your cash invested rather than using it to pay interest. This is central to many Smith Manoeuvre implementations.

Tax timing: Capitalizing interest makes it deductible in the year of capitalization. December interest that would otherwise be paid in January can be capitalized in December to accelerate the deduction.

Compound leverage: Capitalized interest becomes principal that itself accrues interest. This is leveraged compounding — your debt grows, but so does your invested capital if you reinvest.

The Smith Manoeuvre connection

The Smith Manoeuvre converts non-deductible mortgage interest into deductible investment loan interest. Many implementations use a readvanceable HELOC and capitalize the investment interest:

1. Each mortgage payment increases available HELOC credit
2. Borrow from HELOC to invest
3. Capitalize the investment interest rather than paying cash
4. Over time, non-deductible mortgage debt converts to deductible investment debt

CRA basis

Interest is deductible when paid, per Income Tax Folio S3-F6-C1. Capitalizing interest is a form of payment — you're using borrowed funds to discharge the interest obligation. Paragraph 1.38 notes that interest on borrowed money used to pay deductible interest is itself deductible.

Related topics

• Mixed HELOC use — capitalization follows the same proportional rules as payments
• How interest is time-weighted — how capitalized principal affects future interest charges
• How interest deductibility works — the core concept