Accrued interest is a type of interest that accumulates over a time period but hasn’t yet been paid. That interest could be paid to a lender (such as on a credit card balance or a loan) or an investor (say, on a bond you bought). It’s different from regular interest, and it’s a basic but important financial topic to understand.
So we’ll break it down for you here and share:
• What is accrued interest
• How accrued interest works
• Why it’s important
• How to calculate accrued interest
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 bump into accrued interest.
This type of interest accrues in between payments; it’s just a matter of time before it is paid out. Let’s say you have a balance of $1,000 on your credit card, and you make a partial payment on the 30th of the month. Once you make that payment, 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 (or, in the case of investments, until a payout is made).
How Does Accrued Interest Work?
It’s possible to owe accrued interest on a variety of lending products, like the credit card we mentioned above. It’s also possible to earn accrued interest on investing products and savings accounts.
Whenever someone is borrowing money, they owe interest. They are paying for the privilege of using someone else’s money. On the flip side, when they give a financial institution, government agency, or company money to borrow for an investment such as a bond, then the investor is owed interest.
Now that you understand that concept, let’s look a bit deeper. With installment loans, such as a line of credit, interest typically accrues daily. At the end of the month, the interest accrued is added to the total monthly payment amount. With credit cards, the same daily accrual happens after the card holder makes a charge with their plastic. The interest is building up as the month goes on. How much interest accrues depends on the balance of the lending product and the interest rate. Of course, if the balance gets paid off in full, interest won’t be accruing (not until the next charge is made, at least).
Accounts that earn interest, such as certificates of deposits and high-yield savings accounts, also tend to accrue interest daily. The amount of interest accrued is based on the account’s average daily balance. An exception: bonds, which generate a fixed interest payment on a quarterly, semiannual, or annual basis.
Recommended: How Do Credit Card Payments Work?
Example of How Interest Can Accrue
Let’s look at an example of how interest can accrue.
• Acme Corp took out a loan of $200,000 with a bank at an annual interest rate of 10%.
• This loan will mature within one year, and any remaining principal and interest payments will be due in full at that maturation date.
• Acme Corp must make monthly interest payments based on the annual interest rate they received from the bank.
• During the life of this loan, Acme Corp will owe $54.79 in interest on a daily basis for that 365-day loan term.
• The accrued interest will be due once a month and will accumulate to $1,666.67.
• This accumulated interest is what is known as accrued interest. Once Acme Corp pays it off at the end of the month, the amount of accrued interest owed will reset to zero and begin to accumulate again.
Accrued Interest vs Regular Interest
So, what is the difference between accrued interest and regular interest (the latter is sometimes known as simple interest, as opposed to compound 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 matters because it illustrates how interest that a consumer owes or is owed adds up. For example, with bonds, it can help you understand the interest that’s collecting 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 will impact your future financial health.
If someone sees how long it will take to pay off a credit card balance over three years, they may want to crunch the numbers on how much interest they will accrue in the next couple of years. They may find that paying the debt ASAP saves them a lot of money. They could figure out how to part with a large chunk of cash at once to avoid the accrual of interest.
Do I Have to Pay Accrued Interest?
The answer to the question “Do I have to pay accrued interest” is yes. Once someone enters a borrowing agreement, they need to pay any interest they accrue. That being said, there are ways they can avoid paying accrued interest altogether or can avoid paying more accrued interest than they need to.
Here’s a few tips for how to minimize accrued interest payments.
• Pay credit cards in full. Interest accrues whenever you make a purchase with their credit card. But if you pay it off in full by the due date, you won’t need to pay any accrued interest.
• Make more frequent payments. To minimize how much accrued interest someone owes, you can make additional payments on top of their regularly scheduled minimum payments. Paying down the principal faster on, say, a loan, will lower how much interest accrues on a monthly basis. You may then be able to pay off the loan early, which also helps avoid more interest accruing.
• Build your credit history. Working on improving your credit score can help you obtain lower interest rates in the future. If you qualify for a better (lower) interest rate when taking out a loan, the amount that accrues on the principal will be lower.
• Have a plan for your debt payoff. If you are juggling multiple sources of debt, you can pay down the debt faster by having a plan in place. You may want to consider the debt avalanche method or debt snowball method.
• Refinance your loan. It’s possible to refinance certain loans like home, auto, and student loans. If you’ve improved your credit score, you may qualify for better interest rates and terms since they first took out the loan. This can help lower the amount of accrued interest you owe and help you pay off the debt faster.
Recommended: When Do Student Loans Accrue Interest?
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 high yield bank account.
For example, to calculate how much interest will accrue with a credit card, all the consumer has to do is divide their APR (annual percentage rate) by 365. If they want to see how much accrued interest they will owe at the end of the month, they will simply multiply that daily amount by how many days are in the statement period. Whenever we talk about credit cards and interest, it’s worth remembering that it’s likely you will make more purchases with your plastic over time. That will boost the amount owed and the interest accrued.
The Takeaway
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. Understanding how that interest builds up is a valuable tool. By better comprehending how much you owe or are owed, you can better manage and 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 be pretty happy about it.
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.
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