In a Nutshell
With some loans or investments, interest adds up daily but is charged or paid out in longer intervals — often monthly or quarterly. The interest that builds up during those intervals is called “accrued interest” because it accrues (or builds up) over time.If you’ve looked at your loan or investment statements lately, you might have seen a line for “accrued interest” or “estimated interest.”
This line is especially important to pay attention to if your loan is in forbearance, or if you’re on an income-driven payment plan, because in some cases that interest could be tacked onto your loan. On the other hand, if you’re thinking about buying or selling an investment, you may need to calculate the amount of accrued interest to make sure the transaction is fair.
“Accrued interest” is an accounting term, but it’s not too tough to understand. Let’s break down what accrued interest means, how it works and how to calculate it.
- What is accrued interest?
- How does accrued interest work?
- Why is accrued interest important?
- Do I have to pay accrued interest?
What is accrued interest?
When it comes to loans, accrued interest is the amount of unpaid interest that has built up since you last made a payment. In the context of student loans, for example, interest may begin accruing at the moment your loan is disbursed and continue to accrue until you pay it off.
In the context of investments — a common example is bonds — accrued interest works in the opposite way it works with loans: You’re essentially lending money to an entity that pays you interest that accrues between payouts.
How does accrued interest work?
Did you know that most loans charge interest daily? But rather than requiring daily payments for that interest, lenders keep a running tally of it that you pay in more reasonable increments. This is where the “accrual” in “accrued interest” comes from.
Many institutions calculate accrued interest based on a 360-day year, broken into 30-day months. When you make your monthly payment, the financial institution takes some of that money and puts it toward the accumulating interest. The rest goes toward paying down your “principal” loan balance (the amount of money you borrowed). This process of divvying up your payments is known as amortization.
As an example of accrued interest: Let’s say your loan accrues $1 in interest every day. If 31 days pass between your payments, you’ll owe $31 in accumulated interest when you make your loan payment. If your regular monthly payment is $100, then $31 will go toward accrued interest, and $69 will go toward your principal.
The process works similarly for investments. For example, the interest you make on Treasury bonds is commonly distributed in six-month intervals. If you continue to hold the bond, you will get your full interest payment on the next payment date.
What if you sell your bond exactly halfway between payments? You technically should be paid half of that bond’s next interest payment. To determine that amount, you can multiply the daily interest payment ($1, for example) by the number of days (90) to see how much extra ($90) you should charge the buyer so you get your fair share of interest revenue.
Why is accrued interest important?
With bonds, understanding how accrued interest works can help you see if you’re getting the interest you’re owed. In the example above: If you sold the bond without accounting for (and collecting) accrued interest, you could be losing money on the sale.
With loans, interest may begin accruing when you first get the loan, depending on the type of loan you have. This is common with private student loans and unsubsidized federal student loans. In these cases, the lender tallies up the interest that accrues on the loan between your payments.
The same goes for when you’re not making payments on your student loans for longer periods, such as when you’re in a period of deferment while still in school or in a hardship forbearance. In such a situation, the accrued interest may be capitalized — meaning added to your principal balance — causing your balance to keep growing. Sometimes, you’ll get the option to pay just the accrued interest portion on your loan while it’s in forbearance. If you can afford it, doing this can save you money over the long run.
Do I have to pay accrued interest?
Another key thing to know is that, with student loans, you may not always have to pay that accrued interest. There are a few ways this can work for people with federal student loans.
If you have a direct subsidized federal student loan, with a few exceptions the government generally pays your accrued interest while you’re not paying the loan yourself — when you’re in school or during the six-month grace period after you leave school, for example, or if you’re in deferment. This means that your loan balance will stay the same from that point until you start paying it back. You won’t have to pay any accrued interest until you start repaying the loan, and then the interest will be limited to the incremental amounts that accrue between your monthly payments.
Things get a bit trickier if your student loans are on an income-driven repayment plan. If you have a big loan balance and very small monthly payments, it’s possible that your payments won’t even cover the accrued interest each month. This is called negative amortization. Each of the income-driven repayment plans (except for the income-contingent repayment plan) has some way for you to avoid paying some or all of the accrued interest if you get into this tough situation.
Next steps: Calculating accrued interest
You can use accrued interest calculators to see how much accrued interest might add up on your student loan while you’re taking a break, and how much interest-only payments can help you in the long run.
If you’re dealing with an investment instead, it’s a good idea to chat with your financial adviser or accountant to see how accrued interest might affect you.
Either way, understanding how accrued interest works can help you be more strategic about your finances.