What Is Accrued Interest?
Accrued interest is the interest that has been earned but not yet paid on loan. The lender records a liability based on the accrued interest amount; this is done to ensure that the lender passes concern on accrual accounting to its customers. This allows you to report earnings from your financial statements fairly.
The term accrued interest is used about a bond’s outstanding interest, which includes both the amount of interest that has accumulated and the amount of interest that is due but hasn’t yet been paid. Accrued interest indicates the amount after it has been added to the bond’s principal value.
Accrual Accounting and Accrued Interest
Accrual accounting is a method of accounting where transactions and events are entered in the books when they occur, regardless of when any related payment is expected to be made by or received from a counterparty. The goal of accrual accounting is to match transactions with their related costs on time. Accrued interest is the amount of interest accumulated on a loan when it gets paid out and when it’s made.
There are several important aspects to accounting that are directly related to the concept of accrued interest. The first is the revenue recognition principle. This states that revenues should be recognized in the period in which they are earned. Next is the matching principle, which states that expenses should be recorded in the same accounting period as the related revenue.
Accrued Interest Example – Accounting
Accrued interest is money you owe on an account that has not yet been paid off. For example, if you borrowed $1,000 at 12% interest and paid it off 50 years later, you would owe money interest of $50.50 each year until paid off. If you gave your company a bill for $2,000 from a line of credit 10 years old with an outstanding balance that has not been paid off, an accrual charge would appear on your credit report for that year and each succeeding year that the balance remains unpaid until paid off.
Accrued Interest Example – Bonds
When buying a bond, the bank will include the interest on your loan. However, this is an advance. When you sell the security, the bank does not get its money back. Interest goes into a pool, and any amount over and above what was borrowed remains on your balance for use at any time of day or night. This is why buying bonds are usually considered risky and is a good way to introduce risk into your investment and increase returns without putting yourself into excessive debt.
For example, say a seller has a $100,000 bond with an interest rate of 8%, and a buyer pays $90,000 at closing. If the seller charges an 8% interest rate on the unpaid balance even after the buyer has paid off the full $100,000, then the buyer would owe the seller an additional $10,000, which added to the original $90,000 would bring the unpaid total above the $110,000 balance owed.
Accrued Interest Formula
AI= T x P x R
Where AI is the accrued interest
T= fraction of the year
R= annualized interest rate
Where T can be calculated as:
N= Number of days in a period
Y= Number of days in a year
Accrued Interest and the Bond Market
When purchasing bonds in the secondary market, accrued interest must be factored into the total purchase price. If you buy a bond sometime between the last coupon payment and the next coupon payment, you will be the bondholder of record and thus receive the interest due on that payment date. When a bond is sold before the maturity date, the buyer must pay the person who originally owned the bond for the interest credited to his/her account yet not earned.
Let’s say the seller of a bond has an option to buy you a new card at the current market price plus 15%. If you take this option, the seller will earn 15% on the current market price plus the value of your tradeable bond. That means they will have paid you more than they would have if they had just bought you the current market price + 15% and paid you in cash.
Accrued Interest and Convertible Bonds
An interest-paying convertible bond is a bond that provides bondholders to receive periodic interest payments from the issuer. In addition, an interest-paying convertible bondholder has the right to convert their bonds into common stock of the issuing company.
When a convertible bond is converted to shares of the issuer, interest payments stop. One final partial payment is made upon conversion to cover the amount that has accrued since the last payment date of record.
What is Regular Interest?
Regular interest is the payment for borrowing a loan that is typically paid back over a while. When you borrow money, you have to pay regular interest on the amount being borrowed. Regular interest can be an income earned on a deposit account that promises higher interest than savings or checking accounts but is not liquid.
Interest on Borrowed Money
When a corporation, business, or individual takes out a loan from a bank or other financial institution, interest rates are predicted to be paid on that loan. These interest rates can change throughout time due to many different reasons, such as the Federal Reserve lending rate, inflation, and various other things.
Interest Rate on Deposits
When you deposit money into an account that pays interest, the bank usually charges a portion of it as interest and keeps some of it to make loans with. The bank gives the customer a small percentage of the interest they charged on loans in return for this service.
Interest income on the deposit will continue to accumulate as long as the customer has money in the account and continues depositing more funds into the account. Interest-earning accounts include money market deposit accounts, savings deposit accounts, and certificates of deposit (CDs).
What is Accrued Interest vs. Regular Interest?
When investing in securities, a stockholder is paid either an accrued interest or a regular interest at an agreed period. Interest payments are paid out at regular intervals. Depending on the period that has elapsed since the last payment was made, investors may be owed money to invest in the security.
Accrued interest is the additional interest that accrues to the principal of a loan or investment that has been outstanding for less than one year. This is distinct from regular interest earned on bank savings or charged on borrowing money from the bank.