What Is the ๊Effective Interest Rate Methꦐod of Amortization?

The effective interest rate method of amortization is an accounting practice used to discount a bond. It is used for bonds sold at a discount or premium, with the amount of the bond disco🍃unt or premium amortized to interest expense over the bond’s life.

Understanding the Effective Interest Rate Method𒈔

The preferred method for amortizing (or gradually expensing the discount) on a bond is the effective interest rate method. Under this method, the amount of interest expense in a given accounting period correlates with the 澳洲幸运5官方开奖结果体彩网:book value of a bond at the beginning of the accounting period. Consequently, as a bond’s book value increases, the amount of interest e꧋xpense increases.

When a discounted bond is sold, the amount of the bond’s discount must be amortized to interest expense over the life of the bond. When using the effective interest method, the debit amount in the discount on bonds payable is moved to the interest account. Therefore, the amortization causes interest expense in each 澳洲幸运5官方开奖结果体彩网:accounting period to be higher than the amount of interest pai𒆙d during each year of the bond’s life.

For example, assume a 10-year $100,000 bond is issued with a 6% semiannual coupon 𓂃in a 10% market. The bond is sold at a discount for $95,000 on Jan. 1, 2017. Therefore, the bond discount of $5💫,000, or $100,000 less $95,000, must be amortized to the interest expense account over the life of the bond.

The effective interest method of 澳洲幸运5官方开奖结果体彩网:amortization causes the bond’s book value to increase from $95,000 on Jan. 1, 2017, to $100,000 prior to the bond’s maturity. The issuer must make interest payments of $3,000 every six months that the bond is outstanding. The 澳洲幸运5官方开奖结果体彩网:cash account is then credited $3,000 on Jun൲e 30🌸 and Dec. 31.

Evaluating a Bond’s Interest

The effective interest method is used when evaluating the interest generated by a bond because it considers the impact of the bond purchase price rather than accounting only for 澳洲幸运5官方开奖结果体彩网:par value.

Although some bonds pay no interest and generate income only at maturity, most offer a set annual rate of return, called the 澳洲幸运5官方开奖结果体彩网:coupon rate. The coupon rate is the amount of interest generated by ꧑the bond each year, expressed as a percentage of the bond’s par value.

A Bond’s Par Value

Par value, in turn, is simply another ter♎m for the bond’s face value, or the stated value of the bond at the time of issuance. A bond with a par value of $1,000 and a coupon rate of 6% pays $60 in interest each year.

A bond’s par value does not dictate its selling price. Bonds that have higher coupon rates sell for more than their par value, making them 澳洲幸运5官方开奖结果体彩网:premium bonds. Conversely, bonds with lower coupon rates often sell for less than par, making them 澳洲幸运5官方开奖结果体彩网:discount bonds. Because the purchase price of bonds can vary so widely, the actual rate of interest ꦕpaid each year also varies.

If the bond in the above example sells for $800, then the $60 interest payments it generates each year represent a higher percentage of the purchase price than the 6% coupon rate would indicate. Although both the par value and coupon rate are fixed at issuanc⛎e, the bond pays a higher rate of interest from the investor’s perspective. The effective interest rate of this bond is $60 ÷ $800 or 7.5%.

If the 澳洲幸运5官方开奖结果体彩网:central bank reduced i♛nterest rates to 4%, this bond would automatical🌳ly become more valuable because of its higher coupon rate. If this bond then sold for $1,200, its effective interest rate would sink to 5%. While this is still higher t๊han newly issued 4% bonds, the increased selling price partially offsets the effects of the higher rate.

What Does the Effective Interest Rate Tell You?

In accounting, the effective interest rate method examines the relationship between an asset’s book value and related interest. In lending, the 澳洲幸运5官方开奖结果体彩网:effective annual interest rate might refer to 💙an interest calculation wherein compounding occurs more than once a year. In capital finance and economics, the effecti💮ve interest rate for an instrument might refer to the yield based on the purchase price.

All of these terms are related in some way. For example, effective interest rates are an impo𓄧rtant component of the effective interest method.

An instrument’s effective interest rate can be contrasted with its 澳洲🥃幸运5官方开奖结果体彩网:nominal interest rate or real interest rate. The effective rate takes two factors into consideration: purchase price and 澳洲幸运5官方开奖结果体彩网:compounding.

For lenders or investors, the effective interest rate reflects the actual return far better than the nominal rate. For borrowers, the effective interest rate shows costs more effectively♛.

Put another way, the effective inte🦋rest rate is equal to the nominal return relative to the actual principal investment. In terms of accounting for bonds, the effective interest rate is the same as a bond’s yield at the issue date.

An interest-bear▨ing asset also has a higher effective interest ra♋te as more compounding occurs. For example, an asset that compounds interest yearly has a lower effective rate than an asset that compounds monthly.

Unlike the real interest rate, the effective interest rate does not take 澳洲幸运5官方开奖结果体彩网:inflation into account. If inflation is 1.8%, a 澳洲幸运5官方开奖结果体彩网:Treasury bond (T-bond) with a 2% effective interest rate has a real inter⭕est rate of 0.2% or the effectiveꦆ rate minus the inflation rate.

Benefits of Effective Interest Rates

The primary advantage of using the effective interest rate is simply that it is a more accurate figure of actual interest earned on a financial instrument or investment or of actual interest paid on a loan, such as a home mortgage.

The effective interest rate calculation is commonly used in relation to the bond market. The calculation provides the real interest rate returned in a given period, based on the actual book value of a financial instrument at the beginning of the period. If the book value of the investment declines, then ♔the interest earned will decline as well.

Investors and analysts often use effective interest rate calculations to examine premiums or discounts related to government bonds, such as the 30-year U.S. Treasury bond, although the same principles apply to corporate bond tr🗹ades. When the stated interest rate on a bond is higher than the current market rate, traders are willing to pay a premium over the face value of the bond. Conversely, whenever the stated interestജ rate is lower than the current market interest rate for a bond, the bond trades at a discount to its face value.

Actual Interest Earned

The effective interest rate calculation reflects actual interest earned or paid over a specified time frame. It is considered preferable to the 澳洲幸运5官方开奖结果体彩网:straight-line method of figuring premiums or discounts as they apply to bond issues because it is a more accurate statement of interest from the beginning to th🌞e end of a chosen accounti♚ng period (the amortization period).

On a period-by-period basis, accountants regard the effective interest method as far more accurate for calculating the impact of an investment on a company’s bottom line. To obtain this increased accuracy, however,❀ the interest rate must be recalculat🌼ed every month of the accounting period; these extra calculations are a disadvantage of the effective interest rate. If an investor uses the simpler straight-line method to calculate interest, then the amount charged off each month does not vary; it is the same amount each month.

What Is the Difference Between the Effective Interest Rate and the Stated♐ Interest Rate?

Whenever an investor buys, or a financial entity such as the U.S. Treasury or a corporation sells a bond instrument for a price that is different from the bond’s face amount, the actual interest rate earned is different from the bond’s stated interest rate. The bond may be trading at a premium or at a discount to its 澳洲幸运5官方开奖结果体彩网:face value.

In either case, the actual effective interest rate differs from the stat🔯ed rate. For example, if a bond with a face value of $10,000 is purchased for $9,500 andꦬ the interest payment is $500, then the effective interest rate earned is not 5% but 5.26% ($500 divided by $9,500).

For loans such as a home mortgage, the effective interest rate is also known as the 澳洲幸运5官方开奖结果体彩网:annual percentage rate (APR). The rate takes into account the effect of 澳洲幸运5官方开奖结果体彩网:compounding interest along with all the𝓰 other costs tha𒆙t the borrower assumes for the loan.

The Bottom Line

When a bond fluctuates in price from its par value, it impacts the actual interest rate paid by the bond, known as the effective interest rate. In this way, the effective rate accounts for the purchase price and compounding. As a result, the effective rate is a more accurate indicator of a bond's return than the nominal interest rate.