In financial terminology, "accrues" means the same thing as "accumulates." Interest is considered accrued when it is added to the balance on the account, which accrues on loans such as a mortgage, on savings accounts, student loans, and on other investments.
Interest can accrue on any time schedule; common periods include daily, monthly and annually. Daily accrual, for example, means interest amounts are added to the account balance every day. Some modern computations have interest accrue continuously based on mathematical formulas that slice time more and more finely as time approaches zero.
- Companies will accrue interest daily if they are worried about the principal capital of the loan being reduced substantially before expiration. This is most commonly seen with credit cards and margin loans from investment brokerages.
- As a consumer, it is much more beneficial to purchase loans that accrue monthly or yearly. They are more predictable, and have a psychological benefit as well.
- Generally speaking, debtors are better off with less frequent accrual and compounding periods, while savers are better off with more frequent periods.
Daily Accrual Example
Consider a $100,000 mortgage loan with a 15% APR accrued daily. Assuming the contract has a 365-day year (some are 360), the daily interest rate can be found by dividing 15 by 365. This calculation yields a daily interest rate of 0.0410958%.
The accrued interest on the first day of the mortgage is equal to $100,000 x 0.0410958%, or $41.0958. The account balance on day two equals $100,041.10 after rounding. Moving beyond day two, interest accrual depends on the compounding period.
Companies make the most money when they accrue interest daily.
There are some types of lenders who use daily accrual almost across the board. The most obvious example of this is credit card companies, who have learned how to leverage their often exorbitant annual percentage rates into making the most money for their company.
Another example is when an investor takes a margin loan from their brokerage. Since margin loans are usually used for investments over a short period of time, the brokerage needs to accrue interest daily to make a profit off their loan.
Accrual and compounding periods are often different. Compounding changes the account balance from which the accrual calculations take place. If interest compounds monthly, then every month has a "compound date" where past accrued interest is summed and becomes the new base balance.
Take the previous $100,000 mortgage example. Under monthly compounding, the daily accrual amount, $41.0958, is the same for each day in the first month. On the compound date, all of the total accrued interest to that point is added to a new base amount. Every day in the second month uses the new, compounded loan balance.
Einstein famously said, regarding compound interest, that "He who understands it, earns it; he who doesn't, pays it." It is vital for investors to realize that debts are the opposite of investments, and it is often better to pay down debt—especially the type that compounds daily—than it is to chase new investment opportunities. It is not as flashy, but it is often the best move for your financial freedom.