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 discount bond is a bond that is issued for less than its par ...
  2. Below Par

    Below par is a term describing a bond whose market price is below ...
  3. Pull To Par

    Pull to par is the movement of a bond's price toward its face ...
  4. Unamortized Bond Discount

    An unamortized bond discount is a difference between the par ...
  5. Dollar Price

    Dollar price is a method of pricing a bond in value terms, not ...
  6. Current Yield

    Current yield is the annual income (interest or dividends) divided ...
Related Articles
  1. Investing

    The Basics Of Bonds

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

    Investing in Bonds: 5 Mistakes to Avoid in Today's Market

    Investors need to understand the five mistakes involving interest rate risk, credit risk, complex bonds, markups and inflation to avoid in the bond market.
  3. Investing

    Why Bond Prices Fall When Interest Rates Rise

    Never invest in something you don’t understand. Bonds are no exception.
  4. Investing

    How Interest Rates Impact Bond Values

    The relationship between interest rates and bond prices can seem complicated. Here's how it works.
  5. Investing

    6 Ways That Investors Use Bonds

    Learn how the stodgy stereotype of bonds can overshadow the basic and advanced uses of what these investments can do for your portfolio.
  6. Investing

    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.
  7. Investing

    Corporate Bonds for Retirement Accounts

    Corporate bonds are usually the preferred choice in retirement accounts. Here are some of the benefits of corporate bonds, and strategies for a portfolio.
  8. Investing

    Premium Bonds: Problems And Opportunities

    Learn all about premium bonds and how you can make them work for you.
  9. Investing

    The Best Bet for Retirement Income: Bonds or Bond Funds?

    Retirees seeking income from their investments typically look into bonds. Here's a look at the types of bonds, bond funds and their pros and cons.
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. What is the effective interest method of amortization?

    Find out more about the rationale and advantages of the effective interest rate method and how it is used to amortize a discounted ... Read Answer >>
  3. What determines bond prices on the open market?

    Learn more about some of the factors that influence the valuation of bonds on the open market and why bond prices and yields ... Read Answer >>
Hot Definitions
  1. Current Assets

    Current assets is a balance sheet account that represents the value of all assets that can reasonably expected to be converted ...
  2. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  3. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  4. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
  5. Depreciation

    Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account ...
  6. Ratio Analysis

    A ratio analysis is a quantitative analysis of information contained in a company’s financial statements.
Trading Center