Question:

How is calculation of accrued interest done?

Answer:

Calculation of accrued interest is done mainly using the formula A = D x P x EAR, where

  • A is the accrued interest;
  • D is the ratio between the number of days we are calculating interest on and the number of days in the year;
  • P is the principal;
  • EAR is the effective annual rate.

Important Features of Accrued Interest Calculation

Have in mind that EAR is not always the announced rate of the loan instrument. Some loans will use different compounding periods and sometimes the rate on the quote has to be re-calculated to show the EAR - effective annual rate. The interest rate may be calculated on a daily, weekly, monthly, quarterly, yearly, etc basis. EAR is the quoted rate but annualized.

When calculating accrued interest, you also have to know that D depends on the number of days in the year assumed by the lending institution. D is calculated as X over Y, where X is the number of days we are calculating interest on, and Y is the number of days in the year. Some institutions will use 360 or 365 days in a year; leap years can be ignored or taken into account in the calculation. A common convention is a 30-day month and a year of 360 days for ease and predictability of calculations.

Another convention used by businesses that affects calculation of accrued interest is rolling interest into the next or previous business day, depending on necessity. Sometimes a payment will arrive right after, say, 5 pm when the banking systems are already shut down. It may be applied towards the next business day, or to the previous one, depending on judgment of the loan officer responsible for acknowledging the transaction.

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