What is Accrued Interest?
Masterworks What is Accrued Interest?
Accrued interest is the amount of interest accumulated on a loan or debt security but not yet paid.
The amount of interest is calculated based on the interest rate, the principal amount of debt, and the time between interest payments. This concept is important in finance, as it affects the value of the debt security and the amount that must be paid when the security is sold before the next interest payment.
Accrued interest can take two forms: it can be an accrued interest expense owed by the borrower or an accrued interest income owed by the bank to its customers on their deposits. The total amount of accrued interest should be recognized and recorded in the financial statement before payment is received.
The interest recognized as an expense by the borrower but not yet paid to the lender is referred to as “accrued interest payable” and recorded as an expense in the financial statement.
On the lender’s side, the interest recognized as revenue but not yet received from the borrower is called “accrued interest receivable” and recorded as revenue in the financial statement. Unpaid interest revenue or expense is reflected as either an asset or liability in the balance sheet.
Accrued Interest for Bonds
In the context of bonds, accrued interest refers to the accumulated interest since the last bond interest payment period, calculated as of the end of the current accounting period, which could be a month, quarter, or year. This is recorded in the financial statements through an adjusting journal entry at the end of the accounting period.
Accrued Interest Accounting
The accrual accounting principle requires transactions to be recognized as soon as they occur, even if payment hasn’t been made. This means that the accumulated interest owed is recorded in the appropriate accounting period when it occurs, rather than when payment is received.
This is in contrast to the cash accounting method, which only records transactions when cash is exchanged. Accrued interest payable is recorded as an expense in the income statement, while accrued interest receivable is recorded as revenue in the income statement. Unpaid interest revenue or expense is reflected as either an asset or liability in the balance sheet.
How Does Accrued Interest Work?
Accrued interest works by calculating the amount of unpaid interest that has accumulated on a debt security or loan from the last interest payment to the present.
Most loans actually charge daily interest but lenders keep a running tally of it that you pay in a more manageable amount. This is where “accrual” comes from.
Institutions often calculate accrued interest using a 360-day year, divided into 30-day months. When making a monthly interest payment, the financial institution uses part of the payment to address the accumulating interest and the remainder to pay down the principal loan balance. This division of payments is known as amortization.
An Example of Accrued Interest
Say your loan accrues $1 in interest daily and 31 days pass before making a payment, you’ll owe $31 in accumulated interest. If your monthly payment is $100, then $31 will go toward the accrued interest, and $69 will go toward paying down the principal.
The same concept applies to investments. For example, interest earned from Treasury bonds is often paid out semi-annually, but the coupon rate is posted as the annual interest rate. If you keep holding the bond, you’ll receive the full interest payment at the next payment date.
In the case of selling a bond between interest payments, you’d be entitled to half of the next interest payment. To calculate this amount, you can multiply the daily interest ($1, for example) by the number of days (90) to determine the additional amount ($90) you should charge the buyer to receive your share of the interest revenue.
Why is Accrued Interest Important?
In the case of bonds, an understanding of accrued interest can help you receive the interest that you are owed. As mentioned in the example, failing to account for and collect interest while selling the bond could result in a loss of money.
For loans, interest can start accruing immediately, depending on the type of loan. This is common with private student loans and unsubsidized federal student loans, where the lender keeps track of the interest that accumulates between payments.
Compound Interest vs. Accrued Interest
While both refer to interest that is based on more than just the principal amount – as simple interest is calculated — there is a difference between compound and accrued interest.
Accrued interest refers to interest that has accumulated and remains unpaid. Compound interest refers to the interest that accumulates over time on both the principal and previously earned interest.
Calculating Accrued Interest
By utilizing accrued interest calculators, you can estimate the amount of interest that may accumulate on your student loan during a deferral period and how interest-only payments may benefit you over time.
In case you’re involved with an investment, it’s recommended to consult with a financial advisor or accountant to evaluate the impact of accrued interest.
Having a clear understanding of how accrued interest operates can assist you in making informed financial decisions.
What is Regular Interest?
The term “regular interest” refers to the amount of money charged for the use of a loan. Borrowers are obligated to pay interest to the lender, whether it be a bank, credit union, or an individual. Additionally, interest can also be a source of income for an individual who has deposited money into an interest-bearing account.
Accrued Interest vs. Regular Interest
When investing in stocks and bonds, investors receive either accrued interest or regular interest charges at a predetermined interval. These interest payments are not made instantly, and security issuers owe investors a certain amount of money at any given time, based on the elapsed time since the last payment was received.
Accrued interest agreements have fees calculated based on the current account balance and rate.
If you have a regular interest loan, the repayment due will always be the same. A regular interest agreement establishes a set interest rate and usually a payment amount that spans the term of the loan. For example, at the end of the month, you would pay the same interest repayment amount.
Whereas, if your interest accrues over time, the amount paid each accounting period will vary.
Interest Rates on Deposits
When you put money into an interest-bearing account, the bank pays you a percentage of interest for the use of your funds. Banks often lend out the money in these accounts to borrowers and pay a lower interest rate to the account holders.
As long as the funds remain in the account and more is added, the interest income accumulates. Some examples of accounts that earn interest include money market accounts, certificates of deposit and savings accounts.
The Bottom Line
Accrued interest is an important aspect in finance, as it represents the amount of interest that has accumulated but hasn’t yet been paid or received.
The accrual accounting principle recognizes transactions when they occur, while the cash accounting method only recognizes transactions when cash changes hands. Accrued interest can be an expense for borrowers or income for lenders and is recorded in the financial statements as such.
Understanding the concept of accrued interest is crucial for anyone involved in finance or investing in debt securities.
The information in this article is given for educational purposes only. This information is not to be construed as investment advice, or form the basis of an investment decision.
