Accrued interest represents the interest that accumulates in between payments on a financial product. Accrued interest can apply to both lending and investment products, ranging from home loans and credit cards to bonds or savings accounts.
Accrued interest is different from regular interest, and it’s an important concept to understand.
What Is Accrued Interest?
When you are investing and earning interest, you’ll probably encounter accrued interest. And in the opposite situation, if you borrow money and owe interest payments, you’ll also deal with accrued interest.
This type of interest accrues in between payments. For instance, if you have a credit card balance of $1,000, and you make a partial payment on the 30th of the month, the remaining balance and any new charges will begin to accrue interest. It will be due on the 30th of the following month.
Think of accrued interest as interest that is building up, bit by bit, until that payment is made. In the case of an investment like bonds, in which you’re essentially loaning money to an entity like the government or a company, the accrued interest is interest earned on the money you invested that is eventually paid to you.
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How Does Accrued Interest Work?
It’s possible to owe accrued interest on a variety of lending products, like credit cards and loans. It’s also possible to earn accrued interest on certain investing products and savings accounts.
Whenever an individual borrows money, they owe interest. They are paying to use that money. On the flip side, when they are investing and giving a financial institution, government agency, or company money to borrow for an investment, such as a bond, then the individual is owed interest.
Accrued Interest When Borrowing Money
When you borrow money, with an installment loan, for instance, interest typically accrues daily. At the end of the month, the accrued interest is added to the total monthly payment amount.
With credit cards, unless you pay your balance in full every month, the same daily accrual happens after the cardholder makes a charge with their card. The interest is building up as the month goes on. How much interest accrues depends on the balance and the interest rate.
Accrued Interest When Saving
Accounts that earn interest, such as certificates of deposits (CDs) and high-yield savings accounts, also often accrue interest daily. The amount of interest accrued is based on the account’s average daily balance. An exception to that is bonds, which generate a fixed interest payment on a quarterly, semiannual, or annual basis.
How to Calculate Accrued Interest
How interest accrues varies by the lender and product that’s generating the interest, which could be a loan, a line of credit, an investment product, or a bank account such as a savings account.
Example of Accrued Interest When Borrowing
To calculate how much interest will accrue daily with a credit card, for example, an individual needs to divide their APR (annual percentage rate) by 365 (for the number of days in a year). Then, they would multiply their current credit card balance by their daily rate. So if a credit card has an APR of 24.37% with a balance of $500, the calculation for how much interest accrues daily looks like this:
24.37 / 365 = 0.067%
$500 x 0.00067 = $0.34 interest that accrues daily
To calculate the monthly interest charge, multiply the daily rate by the number of days in the credit card billing cycle. So if there are 30 days in the billing cycle the calculation would look like this:
$0.34 x 30 = $10.20 in interest
Although credit card interest accrues daily, the total amount accrued is typically not added to your balance until the end of the billing cycle. So if you pay your balance in full by the due date, you can avoid paying accrued interest.
Example of Accrued Interest When Saving
To calculate accrued interest on a savings account, for example, take your yearly interest rate, which banks generally list as an APY, or the percentage of total interest you can earn on your account per year. To find the monthly interest rate, divide the APY by 12 (for the number of months in the year). So, if the APY is 5%, the calculation would look like this:
5 / 12 = 0.416% monthly interest rate
Next, to calculate how much interest you will actually earn on your money, you need to know if the interest is simple interest vs. compound interest. Most savings accounts use compound interest, and it is calculated depending on how often it compounds, such as monthly.
To determine how much annual interest you’ll earn on a balance of $1,000 in your savings account, the formula is:
P(1 + R / N)˄NT
P is the principal amount (the $1,000), R is your APY (calculated in decimal form), N is the frequency of compounding, which is monthly, and T is the amount of time, which in this case is 1 for one year. It would look like this:
1,000(1+ 0.05 / 12)˄12 x 1 = $1,250
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Accrued Interest vs Regular Interest
Accrued interest is different from regular interest. Accrued interest typically indicates interest charges that have accumulated but not yet been paid. Perhaps you have heard the term in this context with student loans: The interest may start accruing (adding up) when the loan is disbursed, but it could only become due at your studies’ completion. You may not be paying the interest just yet, but you can know the interest will be assessed.
Regular interest refers to the interest earned on, say, a home loan. Your payment plus interest is due on a certain date and is not accruing day after day or varying. The “regular interest” involves a known principal and interest rate, as well as a constant monthly payment that is due every month.
Why Is Accrued Interest Important?
Accrued interest shows how interest that an individual owes or is owed adds up. For example, with bonds, it may help you understand the interest that’s accruing so you can make sure you are earning the right amount. Or, if you have borrowed money, you can look at how the accruing interest could add to the amount you owe, which might, in turn, help you manage your money.
In the case of a credit card, if an individual sees how long it will take to pay off a credit card balance over a year or two, they could crunch the numbers on how much interest they will accrue during that time. They may find that paying the debt sooner could save them a lot of money, and then work to create a budget to help them pay down what they owe.
Understanding how that interest builds up is a valuable tool. By better comprehending how much you owe or are owed, you can manage your money and work to enhance your financial health.
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FAQ
Is accrued interest good or bad?
Accrued interest isn’t necessarily a bad or good thing. If someone borrows money, they may not enjoy paying accrued interest, but it is a part of their lending agreement. On the other hand, if someone earns accrued interest on investments or savings, they’ll probably consider it a good thing.
Why do I have to pay accrued interest?
Paying accrued interest is more often than not necessary when someone borrows money. Those payments are required by lenders in exchange for lending money to consumers.
What is the difference between interest and accrued interest?
Regular interest represents the payment made in exchange for borrowing money or as a form of income earned from an investment. Accrued interest represents the amount of interest that builds up in between payments.
How do you avoid accrued interest?
When an individual enters a borrowing agreement, they need to pay any interest they accrue. That said, there are ways to avoid paying accrued interest altogether or to minimize accrued interest payments. For instance, pay your credit cards in full. When you pay the balance in full, you won’t have to pay any accrued interest.
Also, to minimize how much accrued interest you owe on a loan, you can make additional payments. Paying down the principal faster will lower how much interest accrues on a monthly basis. You may even be able to pay off the loan early, which also helps avoid more interest accruing.
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