What is Accrued Interest?

Accrued interest is the amount earned on a debt or investment that has not yet been paid to the lender or investor. In other words, it is money that someone is owed for letting another person borrow their money but hasn’t yet received that money. Interest can accrue on various financial products, like bonds, loans, notes, certificates of deposit (CDs), etc.

How Accrued Interest Works

Let’s say you loan your buddy Joe $1000 and charge him 12% annual interest. You two agree that Joe will pay you back the full $1000 plus all the interest he owes you at the end of one year.

Now, each day that passes, Joe owes you more interest on that $1000 he borrowed. After one month, he would owe you about $10 in interest ($1000 x 12% annual interest / 12 months = $10). That $10 is considered accrued interest, which Joe owes you but hasn’t paid you yet.

As each month goes by, that accrued interest keeps growing. After 6 months, it would be about $60. By the end of the year, when the loan term is up, the total accrued interest would be around $120, which is what Joe would pay you, along with the original $1000 he borrowed.

Why Accrued Interest Matters

Accrued interest is super essential for both lenders and borrowers to understand for a few key reasons:

It Affects Your Real investment Returns

If you buy a bond or lend someone money, the interest rate tells you what percentage return you should earn on that investment. But when and how you receive those interest payments can impact your take-home returns.

For instance, let’s say you bought a bond with a 6% annual interest rate, and it pays out the interest owed to you every quarter. After the first quarter, you’d be owed about 1.5% in accrued interest (6% / 4 quarters). But if that bond issuer doesn’t pay out that 1.5% to you and instead lets it keep accruing, your bond would be worth 1.5% more than what you paid. If you tried to sell it before receiving the interest payout, you’d want that accrued interest to be factored into the bond’s price, otherwise you’d be missing out on money you were owed.

It Can Catch You Off Guard as a Borrower

On the flip side, if you’re the one borrowing money, accrued interest can sometimes lead to unpleasant surprises. Many loans, like mortgages and car loans, require you to pay both principal and interest with each monthly payment. The interest portion is how the lenders make their money.

However, some loans can let interest accrue without requiring regular payments. And if you’re not carefully tracking how much interest you’re racking up, you might be shocked at the mountain of accumulated interest you owe at the end of your loan term.

Take student loans, for example. Many student loans allow you to defer payments while still in school. But in many cases, your interest still accrues during that deferment period. If you’re not paying it down as it accrues, you could graduate and suddenly find that you owe way more than you originally borrowed because of accumulated interest on top of your principal. Sneaky right?

It Gets Factored into Some Important Financial Calculations

Accrued interest also plays a role when calculating certain financial health metrics, like a company’s free cash flows. Many companies hold investments that pay out interest, like bonds, and that interest counts as investment income.

But remember, interest doesn’t always get paid out regularly. So, when a company calculates its free cash flow for a specific period, it counts the interest it has been paid and the interest it has accrued and is owed. It’s still real income, even if it hasn’t yet hit the company’s bank account.

The same concept applies when calculating a mutual fund’s net asset value (NAV). To determine the most accurate value of a fund that holds bonds, you need to include the face value of those bonds and the value of any interest those bonds have accrued.

Different Types of Accrued Interest

Interest can accrue in a few different ways depending on the type of debt. The main methods are:

Simple Interest

The simplest way (hence the name). Interest accrues as a flat percentage of the principal balance. So, if you have a $1000 loan with 10% simple annual interest, you’ll owe $100 in interest after one year, $200 after two years, $300 after three years, and so on. The amount of interest owed each year is the same since it’s not compounding.

Compound Interest

This is where things get more powerful and more complicated. With compound interest, the interest you earn each period gets added to your principal balance, so you start earning interest on your interest in future periods.

If you have a $1000 investment that earns 10% compound annual interest, you will earn $100 in interest after the first year, just like simple interest. But in year two, that $100 would be added to your principal, so you’d earn 10% on $1100, which comes to $110. And in year three, you’d earn 10% on $1210 ($1000 initial principal + $100 from year one + $110 from year two). As you can see, your money grows faster with compound interest than with simple interest.

Continuous Compound Interest

An extreme form of compound interest, where the compounding periods are broken down into infinitely small slices of time. This is usually more of a theoretical calculation than a practical scenario you’ll encounter in real life. Most compounding occurs annually or monthly. However, understanding the concept of continuous compounding helps illustrate just how powerful compound interest can be.

To wrap things up

We covered a lot of ground here, but the key takeaways about accrued interest are:

• It’s the interest that a borrower owes a lender but hasn’t paid yet
• It applies to all types of interest-bearing debt or investments
• It affects your actual investment returns and loan costs
• It factors into things like a company’s cash flows and a mutual fund’s value
• It can accrue in different ways, like simple interest vs. compound interest
• You need to track it carefully so it doesn’t catch you by surprise

Accrued interest is one of those financial concepts that initially sounds complicated and technical. But it boils down to a simple idea — interest owed but not paid. By understanding how accrued interest works and how it affects your finances, you’ll be better equipped to make smart money decisions, whether investing, borrowing, or lending. Get your accrued interest ducks in a row, and you’ll be ahead!