The Difference Between Earned, Accrued, & Paid Interest
Difference between Earned, Accrued, & Paid Interest
Are you looking for a way to build wealth? Whether you’re just getting started in the world of investing, or you’re a pro, you really need to have a firm understanding about the concept of interest.
The most common types of interest are accrued interest, paid interest and earned interest. What does each of these terms mean? And more importantly, how are they different?
Learn about the various types of interest - from accrued, to paid, to earned - here, as we discuss everything you need to know, so you can get the most out of borrowing, lending and investing.
What is Interest Earned?
Interest earned is the rate at which an investment earns value on top of principal. Usually, earned interest is expressed as either a total dollar amount, or as a percentage of your total portfolio or investment.
For example, if you have an investment valued at $40,000, and you earn $4,000 in interest over the course of the twelve months, that year your total investment value will have grown to $44,000. This represents earned interest of $4,000, or 10 percent.
What is Accrued Interest?
Accrued interest is the amount of interest your investment is currently earning, but that you haven’t yet collected. If you have a savings account, there’s an interest rate that’s associated with your account balance. Generally, the interest is only added on a monthly or quarterly basis, but the interest technically is accruing every day, even if you can’t access the growth until the end of the period.
You can factor how much you’ll be earning on your money because you know the interest rate. But you cannot necessarily spend it until the period ends and the interest is actually added to your account. Accrued interest is also commonly referred to as interest balance.
What is Paid Interest?
Paid interest is interest you’ve already been credited or paid. As noted, before you actually have access to the interest, it’s simply accruing. But once that sum hits your account or balance, it’s now known as paid interest.
How to Calculate Accrued Interest
To truly understand how interest works, you definitely want to know how to calculate accrued interest. Remember, there are times when accruing interest is good - for example when you’re earning it on your investments, or on money in your savings or money market account. But, there are also times when growing interest can be a negative - like when we talk about credit card debt.
The two most common ways to calculate accrued interest are via monthly and daily calculations.
Monthly Accrued Interest
The most common situations where monthly accrued interest calculations are used can be found on mortgages, car payments, student loan payments and other types of loans.
To calculate monthly accrued interest, you need to:
- Figure out the monthly interest rate by dividing the annual interest rate by 12
- Then, you need to convert this percentage to a decimal by dividing by 100
- Next, you calculate the average daily account balance by adding up the principal on each day and dividing it by the total number of days in a month
- Finally, you take the monthly interest rate and multiply it by the average daily balance to get your monthly accrued interest
Monthly Accrued Interest = Monthly Accrued Interest Rate x Average Daily Account Balance
Daily Accrued Interest
Daily accrual means that interest is added to a balance every day. It’s common when talking about investment brokerage margin loans and credit card debt.
NOTE: From a borrower's standpoint, you’re much better off to have less frequent accrual periods. From a saver’s standpoint, the opposite is true, and your money will grow more quickly with more frequent accrual periods.
Calculating daily accrued interest can be done by:
- Taking the monthly interest rate and dividing it by the number of days in the month - such as 30 or 31 - this will give you the daily accrued interest percentage
- Then, divide this by 100 to shift the percent to a decimal
- After that, multiply your daily accrued interest rate by the average daily account balance to get the daily accrued interest
Daily Accrued Interest = Daily Accrued Interest Rate x Average Daily Account Balance
Ultimately, if you’re looking to build a strong investment portfolio, it’s crucial that you have a firm grasp on the different types of interest, when they’re beneficial, when they’re “bad,” and how they can affect your overall portfolio.
Whether you’re paying interest, or you’re earning it, knowing the small details about how interest works can be the difference between making sound investments or not. Interest can have a significant impact on the value of your portfolio over time.
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