This discount is amortized over time, ultimately leading to an increase in the carrying amount to the bond’s face value. 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. The effective interest method of amortization is a process used to allocate the discount or premium on bonds, or other long-term debt, evenly over the life of the instrument. This schedule is set up in the same manner as the discount amortization schedule in the above exhibit, except that the premium amortization reduces the cash interest expense every period.
When she makes periodic loan payments that pay back the principal and interest over time with payments of equal amounts, these are considered fully amortized notes. After she has made her final payment, she no longer owes anything, and the loan is fully repaid, or amortized. Amortization is the process of separating the principal and interest in the loan payments over the life of a loan. Under the effective interest method, a constant interest rate—equal to the market rate at the time of issue—is used to calculate the periodic interest expense.
Wealth Management Strategies Involving Amortizable Bond Premiums
The table below shows how this discount is amortized using the effective interest method over the life of the bond. Treasury or a corporation sells, a bond instrument for a price that is different from the bond’s face amount, the actual interest rate earned is different from the bond’s stated interest rate. In either case, the actual effective interest rate differs from the stated rate. For example, if a bond with a face value of $10,000 is purchased for $9,500 and the interest payment is $500, then the effective interest rate earned is not 5% but 5.26% ($500 divided by $9,500). Investors and analysts often use effective interest rate calculations to examine premiums or discounts related to government bonds, such as the 30-year U.S.
- Now that you understand the effective interest rate method of amortizing bond premiums and discounts we’ll move on to other long-term liabilities.
- If a bond is issued at face value, the amount of periodic interest expense will be the same as the amount of periodic interest payments to bondholders.
- A bond with a par value of $1,000 and a coupon rate of 6% pays $60 in interest each year.
- When a bond is purchased at a premium, the YTM will be lower than the coupon rate, as the investor has paid more for the bond than they will receive back at maturity.
The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Let’s now consider how to use the effective interest method for both the discount and premium cases.
What Is the Effective Interest Method of Amortization?
For loans such as a home mortgage, the effective interest rate is also known as the annual percentage rate. The rate takes into account the effect of compounding interest along with all the other costs that the borrower assumes for the loan. The primary advantage of using the effective when the effective interest rate method is used, the amortization of the bond premium interest rate is simply that it is a more accurate figure of actual interest earned on a financial instrument or investment or of actual interest paid on a loan, such as a home mortgage. However, some bonds, such as municipal bonds, may be exempt from federal and state taxes.
