How to Calculate Effective Interest Rate: Formula & Examples

The theoretical merit rests on the fact that the interest calculation aligns with the basis on which the bond was priced. Therefore, it can be clearly seen that annual yield increases with the increase in the number of compounding happening per year. As such, the option of daily compounding will offer the best yield for John (effective interest of 9.38% against the stated rate of interest of 9%). Let us take the example of an investment with the stated rate of interest of 10%. Calculate the effective interest rate if the investment is to be compounded twice a year.

With the effective interest method, as with the straight-line method, the total interest expense is $67,024. Importantly, there is no difference in the total interest expense within the 5-year period of time; there is only a difference in the allocation. The information for the journal entry to record the semiannual interest expense can be drawn directly from the amortization schedule. Par value, in turn, is simply another term for the bond’s face value, or the stated value of the bond at the time of issuance. A bond with a par value of $1,000 and a coupon rate of 6% pays $60 in interest each year.

Example 2: Effective Interest Method of Amortization for Bonds Sold with Premium in Excel

In year 2, $81,902.52 is charged 5% interest ($4,095.13), but the rest of the 23,097.48 payment goes toward the loan balance. When the first payment is made, part of it is interest and part is principal. To determine the amount of the payment that is interest, multiply the principal by the interest rate ($10,000 × 0.12), which gives us $1,200. The payment itself ($2,773.93) is larger than the interest owed for that period of time, so the remainder of the payment is applied against the principal. In our discussion of long-term debt amortization, we will examine both notes payable and bonds.

• The concept of effective interest rate is very dependent on the number of compounding happening during a year that finally higher yield or eventually higher redemption value at maturity.
• Bonds that have higher coupon rates sell for more than their par value, making them premium bonds.
• Although the two methods are almost the same for the most part, both of them are added separately here for a better understanding of the format to calculate the effective interest method of amortization in Excel.
• The cash interest payment is the amount of interest the company must pay the bondholder.
• Let’s take a look at the concept of effective interest rate from the bond investor’s point of view.

See below for our total premium/discount amortization schedule for our Series 2022 issue using our Effective Interest Rate to Call method. Note the dynamic of the premium amortization rolling off on the call date, and the discount amortization continuing thereafter, reflective of the dynamic we discussed above. Since her interest rate is 12% a year, the borrower must pay 12% interest each year on the principal that she owes. As stated above, these are equal annual payments, and each payment is first applied to any applicable interest expenses, with the remaining funds reducing the principal balance of the loan. In applying the guidance in (c) in the preceding paragraph, the lender may not change from one alternative to the other during the life of the loan.

INCORPORATION OF COST OPTIMIZATION INTO ORGANIZATION’S STRATEGIC PLAN

There was no premium or discount to amortize, so there is no application of the effective-interest method in this example. Under the effective interest method, the effective interest rate, which is a key component of the calculation, discounts the expected future cash inflows and outflows expected over the life of a financial instrument. In short, the interest income or interest expense recognized in a reporting period is the effective interest rate multiplied by the carrying amount of a financial instrument. As illustrated, the $1,007,000, 5-year, 12% bonds issued to yield 14% were sold at a price of $92,976, or at a discount of $7,024. The table below shows how this discount is amortized using the effective interest method over the life of the bond. The effective interest method is an accounting practice used to discount a bond.

Interest expense is calculated as the effective-interest rate times the bond’s carrying value for each period. The amount of amortization is the difference between the cash paid for interest and the calculated amount of bond interest expense. It is important to understand the concept of an effective interest rate because it is a vital metric for an investor or another financial user. The investors tend to use the effective interest rate predominantly as it is the actual yield received from an investment. As such, the investors lay greater emphasis on the number of compounding per year as a higher number of compounding means greater yield. On the other hand, the perspective changes for a borrower who seeks a lower number of compounding per year as it would keep their interest expense low and result in better profitability.

Step 2: Amortization table under effective interest method

Thus, the bond premium to be amortized yearly under this method comes to $560,000. Usually, whether you can afford a loan depends on whether you can afford the periodic payment (commonly a monthly payment period). So, the most important amortization formula is probably the calculation of the payment amount per period. What are the two methods of amortizing https://www.bookstime.com/ discount and premium on bonds payable? On January 1, 2017, Margaret Avery Co. borrowed and received $400,000 from a major customer evidenced by a zero-interest-bearing note due in 3 years. As consideration for the zero-interest-bearing feature, Avery agrees to supply the customer’s inventory needs for the loan period at lower than the market price.

The lender must select one of the two alternatives and apply the method consistently throughout the life of the loan. For example, if a company buys a financial instrument for $95,000 that has a face amount of $100,000 and which https://www.bookstime.com/articles/amortizing-bond-premium-with-the-effective-interest-rate-method pays interest of $5,000, then the actual interest it is earning on the investment is $5,000 / $95,000, or 5.26%. The effective, or actual, interest rate earned on a bond fluctuates in direct correlation to the bond’s book value.

Bonds Payable

Each year, we add the amortization to the carrying value and repeat these steps to find the next year’s interest expense and discount amortization. Under the effective interest method, a company’s interest expense and amortization amount will change every single year. For example, consider a company that issues 10% bonds with a face value of $100,000 for $95,000. However, the difference between how much it has to ultimately repay in principal ($100,000) and the amount it received from selling the bonds ($95,000) represents an additional cost of financing. Finally, the amortization table format for the effective interest method in Excel is as follows.