What is the 'Effective Interest Method'

The effective interest method is the method used by a bond buyer to account for accretion of a bond discount as the balance is moved into interest income or 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'

The effective interest method comes into play when bonds are purchased at a discount or premium. Bonds are normally issued at 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.

Effective Interest Method and Accretion

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, making the new carrying amount of $384,817, which 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. Bond Discount

    Bond discount is the amount by which the market price of a bond ...
  4. Pull To Par

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

    In finance, discount refers to a situation when a bond is trading ...
  6. Current Yield

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

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  2. Investing

    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.
  3. Investing

    How Interest Rates Impact Bond Values

    The relationship between interest rates and bond prices can seem complicated. Here's how it works.
  4. 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.
  5. 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.
  6. 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.
  7. Investing

    How Rising Interest Rates Impact Bond Portfolios

    A look at the impact that changing interest rates - rising or falling - have on bonds and what investors need to consider.
  8. Investing

    How Bonds Are Vital to a Successful Portfolio

    While bonds are a vital part of an investment portfolio, they are often ignored.
  9. Investing

    U.S. Corporate Bonds: The Last Safe Place to Make Money

    There aren't many other sources right now for relatively safe, steady income.
RELATED FAQS
  1. How a bond's face value differs from its price

    Discover how bonds are traded as investment securities and understand the various terms used in bond trading, including par ... Read Answer >>
  2. How Is Par Value Affected When a Bond Price Falls?

    When you buy a bond, the interest payable is known as the par value of the bond. Find out how the par value is affected when ... Read Answer >>
  3. What are the risks of investing in a bond?

    Are you thinking of investing in bond market? Learn more about bond market investment risk, including interest rate risk, ... Read Answer >>
Trading Center