Effective Interest Method

What is the 'Effective Interest Method'

The effective interest rate is a method used by a bond buyer to account for accretion of a bond discount as the balance is moved into interest income, and to amortize a bond premium into an interest expense. The effective interest rate uses the book value, or the carrying amount of the bond, to calculate interest income, and the difference between interest income and the bond’s interest payment is the amount of the accretion or amortization posted each year.

BREAKING DOWN 'Effective Interest Method'

Bonds are normally issued at a par, or face, value, of $1,000 and sold in multiples of $1,000. If a bond is purchased at less than par, the amount below the par value is the bond discount, and since the bond returns the par amount to the purchaser at maturity, the discount is additional bond income to the buyer. In a similar way, a bond purchased at a price above par includes a bond premium, and the premium is an additional expense to the bond buyer because the buyer only receives the par amount at maturity.

How Accretion Works

Assume an investor buys bonds with a $500,000 par value and a coupon rate of 6%; the bonds are purchased for $377,107, which includes a bond discount from par of $122,893. The bond’s interest income is calculated as the carrying amount multiplied by the at the market interest rate, which is the total return earned on the bond given the discount paid and the interest earned. In this case, assume the market interest rate is 10%, which is multiplied by the $377,107 carrying amount to calculate $37,710 in interest income.

The bond pays annual interest of 6% on a $500,000 par amount, or $30,000, and the difference between the interest paid and interest income, or $7,710, is the amount of the bond discount accretion for year one. The bond accretion for the year is moved into bond income, and the accretion amount is also added to the carrying amount so the new carrying amount of $384,817 is used to calculate bond accretion for year two. At the end of the 10-year life of the bond, the carrying amount is adjusted up to the $500,000 par amount.

Factoring in Bond Amortization

A bond purchased at a premium generates a larger cost of debt for the bond buyer, because the premium paid is amortized into bond expense. Assume, in this case, a 4.5%, $100,000 par value bond is purchased for $104,100, which includes a $4,100 premium. The annual interest payment for the bond is $4,500, but the interest income earned in year one is less than $4,500 because the bond was purchased at a market rate of only 4%. The actual interest income is 4% multiplied by the $104,100 carrying amount, or $4,164, and the premium amortization for year one is $4,500 less $4,164, which equals $336. The amortization of $336 is posted to bond expense, and the amount also reduces the carrying amount of the bond.

RELATED TERMS
  1. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  2. Bond Discount

    The amount by which the market price of a bond is lower than ...
  3. Accretion

    1. Asset growth through addition or expansion. 2. In reference ...
  4. Par Value

    The face value of a bond. Par value for a share refers to the ...
  5. Dollar Price

    The percentage of par, or face value, at which a bond is quoted. ...
  6. Discount

    The condition of the price of a bond that is lower than par, ...
Related Articles
  1. Markets

    Are Bonds Selling At A Premium A Good Investment?

    A bond with a par value – or face value -- of $1,000 is selling at a premium when its price exceeds par.
  2. Managing Wealth

    The Basics Of Bonds

    Bonds play an important part in your portfolio as you age; learning about them makes good financial sense.
  3. Markets

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  4. Personal Finance

    How To Choose The Right Bond For You

    Bond investing is a stable and low-risk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy.
  5. Investing

    What is a Premium Bond?

    A premium bond is one that trades above its face or nominal amount.
  6. Trading

    Top 6 Uses For Bonds

    We break down the stodgy stereotype to see what these investments can do for you.
  7. Managing Wealth

    How To Evaluate Bond Performance

    Learn about how investors should evaluate bond performance. See how the maturity of a bond can impact its exposure to interest rate risk.
  8. Markets

    Understanding Bond Quotes

    A bond quote is a bond’s trading price.
  9. Managing Wealth

    Understanding Bond Prices and Yields

    Understanding this relationship can help an investor in any market.
  10. Markets

    5 Fixed Income Plays After the Fed Rate Increase

    Learn about various ways that you can adjust a fixed income investment portfolio to mitigate the potential negative effect of rising interest rates.
RELATED FAQS
  1. How can I calculate the carrying value of a bond?

    Learn what the carrying value of a bond means, how it can change and the easiest way to calculate a bond's carrying value ... Read Answer >>
  2. Will the price of a premium bond be higher or lower than its par value?

    Find out why the selling price of a premium bond is always higher than its par value, including how changing interest rates ... Read Answer >>
  3. What does it mean when a bond is selling at a premium? Is it a good investment?

    When the terms premium and discount are used in reference to bonds, they are telling investors that the purchase price of ... Read Answer >>
  4. How does the effective interest method treat the interest on a bond?

    Find out why you should look at the effective interest of a bond rather than simply relying on its stated coupon rate when ... Read Answer >>
  5. What happens to the price of a premium bond as it approaches maturity?

    Learn how bonds trade in regard to premiums and discounts, and how bond prices shift closer to par value as bonds approach ... Read Answer >>
  6. How does face value differ from the price of a bond?

    Discover how bonds are traded as investment securities and understand the various terms used in bond trading, including par ... Read Answer >>
Hot Definitions
  1. Duration

    A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. ...
  2. Dove

    An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that ...
  3. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
  4. Front Running

    The unethical practice of a broker trading an equity based on information from the analyst department before his or her clients ...
  5. After-Hours Trading - AHT

    Trading after regular trading hours on the major exchanges. The increasing popularity of electronic communication networks ...
  6. Omnibus Account

    An account between two futures merchants (brokers). It involves the transaction of individual accounts which are combined ...
Trading Center