Accrued interest represents the interest that accumulates on financial products like loans, bonds, and savings accounts between payment periods. It is a key concept in finance that ensures borrowed funds or invested amounts are fairly compensated over time, even if the interest payments haven’t been made yet.
How Accrued Interest Works
When you take a loan or buy a bond, interest accrues daily or periodically based on the agreed interest rate and calculation method. For example, if you have a loan with a 6% annual interest rate payable quarterly, the interest builds up daily and is paid in lump sums on the due dates. Until then, the accumulating interest is “accrued interest.” This means that on any given day between payments, there is interest you owe or are owed but haven’t transacted yet.
For bonds, accrued interest becomes particularly important when buying or selling between interest payment dates. The buyer reimburses the seller for the interest earned from the last payment date to the sale date to avoid unfairly benefiting from interest they did not hold the bond for. This principle applies to various types of bonds, including Treasury bonds, municipal bonds, and corporate bonds.
Practical Examples
- Mortgage Loans: Interest on mortgages accrues daily. Each monthly payment typically covers the accrued interest first, then reduces the principal balance. Understanding accrued interest helps borrowers see how payments affect their loan.
- Bond Purchases: If a bond pays interest semiannually and you buy it in the middle of the period, you pay the seller accrued interest to cover their earnings before the purchase. This is added to the bond’s price.
- Savings Accounts: Interest accrual in savings accounts may happen daily or monthly. Banks calculate daily accrued interest and credit it to your account periodically.
Who Should Understand Accrued Interest?
Borrowers benefit from knowing how interest builds and affects payment amounts and loan payoff. Investors, particularly in fixed-income securities like bonds, need to account for accrued interest to price bonds accurately and calculate yields. Lenders and financial institutions use accrual accounting to record interest income realistically, even if cash has not been received yet.
Common Misunderstandings
- Accrued Interest Isn’t Extra Interest: It is part of the interest already agreed upon, just recognized before payment.
- It Doesn’t Usually Increase Principal: Accrued interest represents owed interest; unless capitalized, it does not add to the loan balance.
- Compound vs. Simple Interest: Accrued interest differs depending on whether interest compounds (interest on interest) or is simple (only on principal). See our Compound Interest article for details.
Tips for Managing Accrued Interest
- Borrowers: Understand your loan’s interest calculation and payment schedule to avoid surprises.
- Investors: Always check accrued interest when buying or selling bonds to ensure fair pricing.
- Lenders: Maintain accurate books with proper interest accrual to reflect earned income.
Related Concepts
- Accrued interest is closely related to the loan’s principal balance and interest calculation methods.
- For detailed bond investment insights, explore our Bond glossary.
- Mortgage-specific interest insights can be found in our Mortgage article.
IRS and Tax Considerations
According to IRS Topic Number 403, accrued interest can affect how interest income or expense is reported for tax purposes, such as with bonds and some loans. Taxpayers should keep accurate records of accrued interest for proper tax reporting.
Summary Table: Accrued Interest at a Glance
| Aspect | Description |
|---|---|
| Applies to | Loans, bonds, mortgages, savings accounts |
| When it accrues | Daily or periodic basis until payment |
| Who pays it | Borrowers (loan interest), bond buyers (purchase) |
| Purpose | Reflects interest earned but not yet paid |
| Calculation formula | Interest rate × principal × time elapsed |
| Common payment cycle | Monthly, quarterly, annually |
Understanding accrued interest is essential for effective financial management whether you’re borrowing funds, investing in bonds, or managing savings. It ensures transparency in how interest is calculated and settled over time.
Sources:
- Investopedia, “Accrued Interest Definition and Examples“
- IRS, “Interest Income and Expense“
- NerdWallet, “Accrued Interest: What Investors Need to Know“
For more on interest concepts, visit our related articles on Compound Interest, Bonds, and Mortgage Interest.
