What Is Unearned Interest?

Unearned interest is interest that has been collected on a loan by a lending institution but has not yet been recognized as income (or earnings). Instead, it is initially recorded as a liability. If the loan is paid off early, the unearned interest portion must be returned to the borrower.

Unearned interest is also called unearned discount.

BREAKING DOWN Unearned Interest

Interest recorded in the books of financial institutions as a result of lending activities is either earned or unearned. Earned interest, as the name implies, is interest income that is earned over a specific period of time from investments that pay the lender a regular series of mandated payments. Interest earned can be generated from bonds through interest payments made to bondholders after a stated period of time.

Unearned interest has been collected but is not recognized as income (or earnings). It is initially recorded as a liability.

Not all interest that is received by a lender is earned. Most lenders schedule loan payments to be made at the beginning of the month. The interest paid by borrowers to compensate lenders for lending them funds for a specified period of time represents interest income to the lender. However, the interest paid by the borrower at the beginning of the month applies to the cost of borrowing for the entire month and, therefore, has not been earned by the lender. For example, assume a borrower, on the first of each month, makes his regular $1,200 payment on a loan of which $240 is the interest portion. The $240 is the borrower’s cost for making use of the loan for the entire month. Since he prepaid the interest, the $240 will not be earned by the lending institution because the principal of the loan has not been outstanding long enough. To recognize this transaction, the cash account is debited (increase in cash) and the unearned interest income account on the ledger is credited. This shows that the bank records such income but recognizes the interest portion as unearned.

If the loan is paid off early, the unearned portion must be returned to the borrower. For example, assume a borrower takes out a 36-month loan on a car. If she pays off the entire loan after 30 months, she will be refunded 6 months interest unearned. This is the amount she will save by paying off the loan early.

Amortization of Unearned Interest

Unearned interest is an accounting method used by lending institutions to deal with long-term, fixed-income securities. Initially recorded as a liability, the unearned interest will eventually be recorded as income in the lending institution's books over the life of the loan as time passes and the interest is earned. This accounting process is referred to as amortizing unearned interest.

When amortizing unearned interest, a portion of the income is allocated to one period at a time. To amortize prepaid interest, the unearned interest income account is debited and the interest income account is credited.

Calculating Unearned Interest

Unearned interest can be estimated using a method known as the Rule of 78. The Rule of 78 deals with precomputed loans, that is, loans which have their finance charges calculated before the loan is made. The Rule of 78 is used to calculate the amount of the finance charge or interest to be rebated in the event that the loan is repaid early. The formula for unearned interest is:

Unearned interest = F x [k(k + 1) / n(n + 1)]

where F = total finance charge = n x M – P

M = regular monthly loan payment

P = original loan amount

k = remaining number of loan payments after current payment

n = original number of payments

For example, a borrower takes a $10,000 loan on a car to be repaid in 48 monthly installments of $310.00. However, she repays the loan after 36 months. The lender’s unearned interest can be calculated to be:

F = (48 x $310) - $10,000

F = $4,880

Unearned interest = $4,880 x [(12 x 13) / (48 x 49)]

Unearned interest = $4,880 x (156 / 2352)

Unearned interest = $4,880 x 0.0663

Unearned interest = $323.67