What Is Accrued Interest?

Whether you’re borrowing money from a lender or putting money into a savings account, the amount that you can pay or earn in interest will likely be a part of your decision-making process.

But while every borrower (including your bank when you invest with them) must pay interest on their loan, loan interest can function differently for each type of loan.

One term you may encounter is “accrued interest.” But what is accrued interest, and how does it impact you? Here’s how accrued interest works and ways you can calculate it for yourself.

What Does Accrued Interest Mean?

When you take out a personal loan or a mortgage, you’re charged interest for the service. This interest rate depends on the principal amount you borrowed. But accrued interest is a specific part of your interest.

Accrued interest is the amount of interest that has grown on the loan but has not been paid out yet by a certain date. Accrued interest is incurred as an expense for the borrower and revenue for the lender.

Accrued interest gets calculated at the end of the loan’s accounting period.

Conversely, when you put money into a savings account or other interest-bearing account, you also accrue interest based on the amount you invest and the interest rate that your bank or other financial institution offers you.

How To Calculate Accrued Interest On A Loan

When calculating your accrued interest on a loan, you’ll usually use this formula:

Accrued interest = Principal owed X (Interest rate / Period of time)

Here are how the elements break down:

Let’s say you borrow $100,000. If your annual interest rate is 5% (0.05) and you divide that by 12 months, your monthly accrued interest would be 0.00416666. Multiply that by $100,000 and your monthly accrued interest would be $416.67.

How Does Interest Accrue On A Mortgage?

Lenders usually calculate mortgage interest based on a monthly schedule. When they do, your interest builds monthly. It repeats the accrual process each monthly period based on the new loan principal balance.

To find the amount you would pay in interest for this accrual method, you start with your yearly mortgage interest rate.

The way most mortgages are paid, you pay more interest upfront and less over the length of the loan. As the mortgage amortizes, more of your payment will go toward the principal.

For example, let’s say you take out a 30-year fixed-rate mortgage of $400,000 at an APR or annual interest rate of 5%. If you use a mortgage calculator and exclude taxes, insurance and other fees, your monthly payment would be $2,147.

To determine how much of that payment is interest, take $400,000 and multiply it by 0.05. The result is $20,000, which divided by 12 gives you $1,667 in interest for each month. By subtracting that from the total payment of $2,147, you find that you paid $481 toward your principal.

That means the balance you have after the first month is $399,519. The same formula repeats for your next payment. Because you paid down a portion of your principal, the amount of interest charged is smaller: $1,665. While it’s only a $2 difference, over time you chip away at your principal and your monthly payment comprises less interest.

How Does Accrued Interest Work On A Personal Loan?

Personal loans use the same basic formula for determining accrued interest as a mortgage. For both loans, your interest is accruing on a monthly basis and you have a fixed monthly payment for the life of the loan.

The difference is that personal loans use simple interest instead of amortized interest. This means that more of your monthly payment goes toward the principal at the outset.

Let’s say that you take out a $40,000 personal loan at an interest rate of 10% with a 5-year (60-month) repayment period. Your monthly payment for the loan would be $850 per month.

For the first month, you would pay $517 toward your principal and $333 toward your interest. With each payment your principal would increase by $4 – $7 a month until the loan is repaid.

The same simple interest principle also applies to student loans and auto loans.

How Do You Calculate Accrued Interest On A Credit Card?

When you borrow money using a credit card, you’ll still use the APR to determine how much interest you accrue gets applied. If you make a purchase and pay it off before the end of the month, your interest accrues on a monthly basis.

However, if you carry a balance over from month to month, the interest accrues daily and your APR becomes a daily periodic rate or DPR.

To calculate your DPR, you would use this formula:

Balance owed X (APR / 365) X number of days in the billing month

Let’s say you carry a balance of $1,000 from one month to the next and your APR is 18.99%.

You would divide 18.99% (0.1899) by 365 for a DPR of 0.052%. Multiply that by $1,000 and your DPR comes out to $0.52 per day. Multiply that by the number of days in the month and you’d have your monthly interest payments. It would be similar to the monthly accrued interest, except in January you’d pay $16.12 in interest but in February you’d pay $14.56 in interest.

After that, the unpaid balance and the unpaid interest both carry over to the next month. The credit card issuer reflects this in your balance statement and the accumulated interest continues to accrue.

How Does Interest Accrue On A Savings Account?

Like a personal loan, your savings account also uses simple interest to determine how much interest is accruing on your account. The difference is that you’re growing your balance over time instead of paying down an initial balance.

Also, instead of using APR, most bank accounts will advertise their annual percentage yield (APY). It’s the measure of your potential annual return on your investment, including compounded interest.

Let’s say you put $1,000 into a savings account with an APY of 4%. You’ll calculate your simple interest by multiplying your starting balance by the APY. So at the end of the first year, you’d have $1,000 plus 4% of $1,000 for a total of $1,040. Here’s where compound interest comes into play.

At 4% accrued interest your $1,000 investment has grown by more than $216 over 5 years. The longer you leave the money in the bank account, the more interest will accrue.

The Bottom Line

Interest accrual varies depending on the type of loan and lender you choose – or the type of investment you’re making. Even so, it’s important to understand how interest accrual comes into play so you can prepare for your potential interest costs or earnings.