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Banking Basics

Understanding Accrued Interest

Accrued interest can add to your debt or help you build wealth, depending on the type and account you have. Accrued interest might sound complicated, but it’s actually fairly easy to understand. Let’s learn about what it means and how to calculate it.

Rachel Velez • June 20, 2022

Have you ever been loan shopping and come across the term “accrued interest”? With most types of debt, as a borrower, you’re not only expected to repay the amount you initially borrowed, but you must also cover interest charges that accrue on top of it. On the other hand, savings accounts and investments can accrue interest that’s paid out to you and can make you money.

Now, you may be wondering how accrued interest is calculated, if it’s taxable, and what financial products accrue interest. Here’s what you should know about how accrued interest works and why it’s important when it comes to your finances. 

In This Article

  1. What Is Accrued Interest?
  2. How to Calculate Accrued Interest on a Bond
  3. How to Calculate Accrued Interest on a Loan
  4. Accrued Interest vs. Other Types of Interest
  5. FAQs
  6. Final Thoughts

What Is Accrued Interest?

Accrued interest is the amount of unpaid interest on a loan, bond, or other financial product. You can make money off of accrued interest when it comes to bonds, investments, and savings accounts. Similar to regular interest, you can think of it as the price a financial institution pays you for borrowing your money — or the price you pay a financial institution to borrow its money. As a borrower, accrued interest can cost you money as it’s the accumulated interest on a loan or credit card that has not been paid yet.

Here’s a closer look at how accrued interest works with different financial products:

Loans

In the context of loans, accrued interest may start at the moment your loan is disbursed and continue to accrue until you fully pay it off. This is also common practice for student loans as well. Additionally, if you take out a mortgage, you typically accrue interest each month in exchange for borrowing the funds to purchase your home.

Investment Accounts

For investment accounts, the amount of interest that accrues is always based on the interest rate you’re given and your principal balance. Accounts that earn interest, such as savings accounts or certificates of deposit (CDs), accrue interest daily, and the yield is based on your average daily balance. 

Bonds

A common example of investments that accrue interest is bonds. When it comes to bonds, the bondholder lends money to the government for a determined amount of time, and the government pays the bondholder back the money plus the interest that accrues between payouts. Also, be aware that if you’ve invested in a bond, you’ll typically receive a fixed interest payment quarterly, semiannually, or annually, not daily.

How to Calculate Accrued Interest on a Bond

Most bonds only pay interest twice a year, and in between payments, your bonds will accrue interest on a daily basis. Typically, a financial services company can calculate the amount of accrued interest for you, but if you want to try it yourself, here’s what you do:

  1. Determine the type of bond you’ve purchased.  (Note: Most corporate and municipal bonds use a 360-day calendar when figuring out accrued interest. Government securities, such as U.S. Treasury bonds, on the other hand, use a 365-day calendar.)
  2. Multiply your given interest rate by the total value of the bond.
  3. Calculate the number of days of accrued interest.
  4. Divide the number of interest days by either 360 or 365 (depending on the type of bond).
  5. Multiply the product of your interest rate and total value by the quotient of your interest days and 360 or 365. This number will be the total amount of accrued interest on the bond.

How to Calculate Accrued Interest on a Loan

For loans, the way interest accrues can vary depending on the lender and the type of loan. With credit cards, card issuers convert your annual percentage rate (APR) to a daily interest rate by dividing it by 365. Here’s how to calculate accrued interest on a loan:

  1. Calculate your daily interest rate by dividing your APR by 365.
  2. Add up your balance at the end of each day in a statement cycle. 
  3. Divide that number by the number of days in the statement period.
  4. Multiply your average daily balance by your daily interest rate.
  5. Multiply the result by the number of days in the billing cycle. This number will be the total accrued interest for the period.

Accrued Interest Formula 

Now let’s use an example to figure out the accrued interest of a loan. Suppose the interest charged on a loan is already calculated daily. Let’s say the yearly rate of interest for the loan is 9%, the loan amount is $5,000, and you make a loan payment each month. Let’s also say the interest rate is charged by the lender monthly.

  • Loan amount = $5,000
  • Interest rate = 9%
  • The period for which the interest is accrued = 30 days

Using the information from above, the calculation of accrued interest would be as follows:

Accrued interest formula = 

Loan amount X (yearly interest/365) X 30

$5,000 X (.09/365) X 30

Accrued interest  = $36.99 per month

There are also many different accrued interest calculators online that can help make the process even easier!

 

Accrued Interest vs. Other Types of Interest

Accrued interest is a type of interest, but there are different types of interest you may pay or earn, depending on if it’s a loan, a credit card, an investment account, or a savings account. It’s a good idea to be aware of the differences to ensure you fully understand what you’re agreeing to when borrowing or lending money.

Accrued Interest vs. Regular Interest

Accrued interest is the accumulated interest charges that have not yet been paid. Regular interest is the interest earned on savings accounts or the interest charged for borrowing money from the bank that’s regularly paid.

Accrued Interest vs. Capitalized Interest 

When a lender adds the accrued interest to the balance that the borrower owes, this is called capitalizing the interest. This means future interest charges are based on the new, higher balance that includes the previously accrued interest. This is most commonly used by student loan lenders.

Accrued Interest vs. Taxable Interest 

Taxable interest is what you’re required to pay when you earn money on taxable income, such as investments. It could also be the interest you receive from a bank, whether it’s for a savings account, checking account, money market, or CD, which are all subject to taxes. 

Accrued Interest vs. Compound Interest

Accrued interest is the interest that accrues on the principal balance over a period of time that hasn’t been paid or paid out yet. Compound interest is the interest that accumulates over time, not just on the principal but on the interest that was previously earned as well.

FAQs

Does interest accrue daily?

Well, it depends! An installment loan will usually accrue interest daily, and that daily number is then included in your monthly payment. With credit cards, interest accrues daily but isn’t applied to your account’s balance if you pay off your balance in full at the end of the month. Bonds and investments can also accrue interest daily, but the interest earned is usually applied and paid out semiannually or annually.

How does accrued interest work in real estate?

Accrued interest is applied to mortgage loans when you purchase a house or a piece of real estate. A mortgage will usually come with large interest charges at the start of your repayment period. However, your interest charges will gradually decrease over time as you pay down your mortgage loan.

Once this happens, more of your monthly payment will go to your principal balance. When you take out a mortgage, the accrued interest is typically charged monthly in exchange for borrowing the funds.

Does accrued interest affect cost basis?

Cost basis refers to the price you pay to purchase a bond, plus any adjustments (such as capital returns or interest). Cost basis is important when it comes to the taxation of a municipal bond. As an investor, it’s critical to know the cost basis and how to calculate it, so you can understand how to report the bond transactions on your tax return.

What’s an accrued interest journal entry?

An accrued interest journal entry is a method of recording the amount of interest on a loan that has already occurred but has yet to be paid by the borrower or yet to be received by the lender. These journal entries are used by accountants, financial advisors, and financial departments whose job is to keep track of these transactions.

Final Thoughts

If you’re borrowing money, being charged accrued interest is often a given. The good news is that you can take steps to limit how much you spend on those interest charges, both on your current credit accounts as well as on future loans. 

On the other hand, when dealing with accrued interest for investments or bonds, this type of interest can benefit you in the long run, as it can add up over time, putting more dollars in your pocket! Understanding the parameters of accrued interest, whether it’s on an investment or a loan, is an important part of keeping your finances in check and will put you on the road to success when it comes to managing money.

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