To understand this, you must know several things:

1. Madrid was chosen as capital in the XVI century, back then Spain´s population was not so concentrated along the coast. For example, the 5 kingdoms that comprised the Iberian península in the XV century had the following populations. Castilla 4 millions, Aragón 1 million, Portugal 1,2 million, Navarra 200.000 and Granada around 300.000
2. Castile was the leading partner in the formation of Spain and, due to the failure of the Comuneros revolt in the 1520´s the King had absolute authority in this kingdom so it is logical that, as this kingdom was his main power base, his capital should be located here.
3. During Charles V reign, Toledo was the capital as it was the traditional capital of Castile. It was only moved to Madrid (70 kilometers to the north) in 1561, durign Philip II reign and the reason was, believe it or not, that there were better hunting grounds around Madrid as it close to a mountain chain and Toledo is in the middle of a plain. 4)After Philip II death, the capital was moved for a few years to Valladolid during his son reign and ended up coming back to Madrid for good in the XVII century.

Charles V (Charles I of Castille, Aragon, Navarre) actually preferred Seville as the "seat" of government of Spain, but he was very much a traveling monarch in reality. His son Philip II chose Madrid due to its geographically center position. This was not a choice that wasn't criticized. It made communication and travel to and from his overseas dominions quite a bit longer. But Philip II built the Escorial and other buildings and his successors largely followed his lead.

The prosperous parts of today's Spain were not so prosperous in the 16th century. Aragon, Catalonia, and Valencia was suffering from economic malady, the plague, and then the expulsion of Moriscos. Castille was the strongest in terms of manpower and economy.

Another question, why did they choose Madrid over Toledo?