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Accrued interest represents the interest that accumulates between payments on a financial product. Accrued interest can apply to lending, savings, 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.
Key Points
• Accrued interest builds up when you borrow money or store money in an interest-bearing account.
• It typically indicates interest charges that have accumulated but have not yet been paid out.
• Interest accrual varies by the lender and product generating the interest, which could be a loan, a line of credit, or a savings account, among others.
• It’s possible to calculate the interest that accrues on your loans or interest-paying accounts using the interest rate and the total balance of the loan or savings.
• Understanding how much you owe or are owed means you can manage your money and work to enhance your financial status.
What Is Accrued Interest?
When your money is in an interest-bearing account, like a savings account, 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’s 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 such as the government or a company, the accrued interest is interest earned on the money you invested that’s 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, including credit cards and loans. You can also earn accrued interest on certain deposit accounts and investing products.
Whenever someone borrows money, they will typically need to pay interest. They’re paying to use that money. On the flip side, when they’re providing money to a financial institution, government agency, or company to borrow, such as with a bond, they are owed interest.
Accrued Interest When Borrowing Money
When you borrow money, such as with an installment loan, interest typically accrues daily. At the end of the month, the accrued interest is added to the total monthly payment amount.
With credit cards, interest also usually accrues daily. The amount of interest that builds up depends on your daily balance and your specific interest rate. That said, most credit cards offer a grace period. If you pay your statement balance in full by the due date each month, the credit card company waives the interest fee. If you do not pay your balance in full, you lose this grace period, and interest will then accrue daily on your balance and new charges as the month progresses.
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, a bond, or a bank account, such as a savings account. It may also vary by a product’s terms, such as how frequently it accrues and compounds interest.
Example of Accrued Interest When Borrowing
To calculate how much interest will accrue daily with a credit card, you need to determine your daily periodic rate, which you can calculate by dividing your APR (annual percentage rate) by 365 (for the number of days in a year). Then multiply your current credit card balance by your daily rate.
Daily Periodic Rate
For example, if a credit card has an APR of 24.37% with a balance of $500, the daily periodic rate is 0.00066767, per this calculation:
.2437 / 365 = 0.00066767
Note that the APR is converted into a decimal first.
Daily Accrued Interest
Next, multiply that rate by your account balance to find your daily accrued interest.
$500 x 0.00066767 = about $0.33 in interest per day
A Note on Compounding: Credit cards generally compound interest on a daily basis. This means on the second day, your interest will be calculated based on a new balance of $500.33. This will result in the daily interest charge increasing over time if the balance is not paid down.
However, while credit card interest usually compounds daily, the total amount is typically not added to your balance until the end of the monthly billing cycle. Furthermore, as mentioned above, most credit cards offer a grace period. So, if you pay your balance in full by the due date each month, the credit card company waives the interest accrued.
Example of Accrued Interest When Saving
In a savings account, interest typically accrues daily. To calculate how much interest will accrue daily, you first need to find your nominal interest rate, which is a base percentage banks use before taking compounding into account. Banks typically provide an annual percentage yield (APY), which reflects the total interest your account will earn over a year, including compounding.
Your bank will provide its nominal interest rates as well as its APY, or you can calculate the nominal rate from your APY with this formula, where n is the number of times the account compounds per year:
Nominal Interest Rate = n x ( (1 + APY)1/n – 1)
For example, with a 5.00% APY compounded monthly (using n=12), the nominal interest rate would be 0.048888. Note that the APY is converted into a decimal for the calculation.
Nominal Rate = 12 x ( (1 + 0.05)1/12 – 1) = 0.048888, or 4.89% if converted into a rounded percentage.
Daily Periodic Rate
The next step is to find your daily periodic rate. Similar to the APR example above, this is done by dividing your nominal interest rate by 365.
0.048888 Ă· 365 = 0.00013394
Daily Accrued Interest
Finally, multiply your daily rate by your account balance (in this case, $1,000) to find your daily interest amount in dollars.
1,000 Ă— 0.00013394 = 0.13394
This means a $1,000 balance would accrue about $0.13 in interest per day.
Accrued Interest vs Regular Interest
Accrued interest is different from regular interest. Accrued interest typically indicates interest charges that have accumulated but have not yet been paid. Perhaps you’ve heard the term in the context of student loans: The interest may start accruing (adding up) when the loan is disbursed, but it might only become due when you complete your studies. You may not be paying the interest just yet, but you 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 isn’t accruing day after day or varying. The “regular interest” involves a known principal and interest rate, as well as a constant monthly payment that’s due every month.
The Takeaway
Accrued interest shows how the 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’re earning the right amount. Or, if you’ve borrowed money, you can look at how the accruing interest could increase 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 them to pay off a credit card balance over a year or two, they could crunch the numbers to see how much interest they’ll accrue during that time. They may find that paying off the debt sooner could save them a lot of money and work to create a budget to help them pay down what they owe.
Understanding how interest builds up is important. 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 a good thing. If someone borrows money, they may not enjoy paying accrued interest, but it’s 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 usually 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 between payments.
How do you avoid accrued interest?
When an individual enters a borrowing agreement, they need to pay any interest they accrue, but there may be ways to avoid or minimize accrued interest. For instance, when you pay your credit card balance in full, the interest will not be charged.
Also, paying down the principal faster with additional payments, if possible, will lower the amount of interest that accrues monthly. You may even be able to pay the loan off early, which also helps you avoid the accrual of additional interest over time.
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