Overview
The first time you probably heard about accrued interest is when you considered student loans. Interest is charged on any type of loan that has an interest rate, which covers the majority of loans. When the loan interest has already been occurred, but the entity that owes this interest has not yet paid it and the lender has not received of the payment so far, you would refer to it as accrued interest.
Simply put, when you have interest on a loan, you are getting charged based on the principal. When it accrues and you are not paying on the loan, that means it is accumulating. Thus, the word accrue simply means accumulate and accrued interest can be thought of as accumulated interest.
It can also be thought of as an interest that an entity earns on a bond, annuity, or any other investment which has not yet been paid out.
Formula
To compute accrued interest, you do not need to make any complex calculations – just use the basic formula presented below.
Example
First, let’s look at an example of an accrued interest for a loan. Let’s assume that your business signed a two-month note payable in the amount of $6,400 on April 15th. The annual interest rate on the note is 14%. What is the amount of interest that has accrued at the end of May? Looking at the formula presented earlier, we first need to calculate the interest rate per day. This will give us 0.03836% or 0.0003836 in decimal form.
Now, we simply need to multiply $6,400 by 0.0003836, which gives us 2.45504 and then, multiply by 45 days. As a result, in one and a half months, you will have an accrued interest of $110.48. In your bookkeeping records, you will make the following journal entry to reflect the accrual of interest on your note payable.
May 31st
Interest Expense
$110.48
Interest Payable
$110.48
Next, we are going to look at an example of accrued interest for a bond. We are going to use the same formula, only the terminology will slightly differ. You have a bond with a face value of $50,000 with a 3.65% coupon rate. Let’s assume that you sold the bond 40 days after the last interest payment date. How much accrued interest should the buyer pay you?
Once again, we have an interest rate or rather coupon rate, which is the yield paid by the issuer, that gives us the amount your bond will earn in an entire year. Thus, we need to divide Instead of a loan amount, we are going to divide 3.65% by 365 days to get a daily rate of 0.01%.
Next, instead of the loan amount, we are going to use the face value of a bond, which is how much you invested in this specific bond. Thus, our calculation will look as follows: $50,000 x 0.01% x 40 days. After doing some arithmetic, we get $200.
What this means is that after the last time you were paid interest, your bond has accrued additional interest in the amount of $200. When you sell this bond, you will want to redeem the money earned in interest. Accordingly, the buyer will pay you $200 on top of the bond price. Similarly, you can calculate the amount of your next bond or any other instrument’s interest payment.