Effective Interest Method

What is the 'Effective Interest Method'

The practice of accounting for the discount at which a bond is sold as an interest expense to be amortized over the life of the bond. Using this method, additional interest expense is calculated using the prevailing market interest rate at the time of the bond issue. The market rate is multiplied by the book value of the bond to find the amount of the discount to be amortized as interest expense each period.

BREAKING DOWN 'Effective Interest Method'

The effective interest method is regarded as one of the preferred methods for amortizing a bond discount. In theory, investors demand a discount on bonds because the market interest rate at the time of issue exceeds the coupon payments on the bond. Thus, by amortizing the discount at the market interest rate, a company's accounting statements more closely reflect the economic reality of the bond issue and the firm's true cost of debt.



RELATED TERMS
  1. Amortized Bond

    A financial certificate that has been reduced in value for records ...
  2. Discount Bond

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

    The amount by which the market price of a bond is lower than ...
  4. Unamortized Bond Discount

    An accounting methodology for certain bonds. The unamortized ...
  5. Bond

    A debt investment in which an investor loans money to an entity ...
  6. Unamortized Bond Premium

    The difference between the par-value or face-value of a bond ...
Related Articles
  1. Home & Auto

    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.
  2. Bonds & Fixed Income

    5 Reasons to Invest in Municipal Bonds When the Fed Hikes Rates

    Discover five reasons why investing in municipal bonds after the Fed hikes interest rates, and not before, can be a great way to boost investment income.
  3. Investing Basics

    What is a Premium Bond?

    A premium bond is one that trades above its face or nominal amount.
  4. Bonds & Fixed Income

    Understanding Interest Rates, Inflation And Bonds

    Get to know the relationships that determine a bond's price and its payout.
  5. Bonds & Fixed Income

    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.
  6. Bonds & Fixed Income

    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.
  7. Bonds & Fixed Income

    Six Biggest Bond Risks

    Don't assume that you can't lose money in this market - you can. Find out how.
  8. Taxes

    Taxation Rules For Bond Investors

    Several factors affect the taxable interest that must be reported. Learn more here.
  9. Bonds & Fixed Income

    Do Long-Term Bonds Have A Greater Interest Rate Risk Than Short-Term Bonds?

    The answer is yes, and there are two main reasons why.
  10. Options & Futures

    Top 6 Uses For Bonds

    We break down the stodgy stereotype to see what these investments can do for you.
RELATED FAQS
  1. What is the effective interest method of amortization?

    Find out more about the effective interest rate method and how the effective interest method is used to amortize a discounted ... Read Answer >>
  2. 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 >>
  3. What are the advantages of using an effective interest rate figure?

    Understand what is meant by the effective interest rate, and learn why the effective rate calculation is preferred over the ... Read Answer >>
  4. What causes a bond's price to rise?

    Learn about factors that influence the price of a bond, such as interest rate changes, credit rating, yield and overall market ... Read Answer >>
  5. What are the key factors that will cause a bond to trade as a premium bond?

    Learn about the primary factor that can cause bonds to trade at a premium, including how national interest rates affect bond ... Read Answer >>
  6. 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 >>
Hot Definitions
  1. Reverse Mortgage

    A type of mortgage in which a homeowner can borrow money against the value of his or her home. No repayment of the mortgage ...
  2. Labor Market

    The labor market refers to the supply and demand for labor, in which employees provide the supply and employers the demand. ...
  3. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  4. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  5. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  6. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
Trading Center