Accrual of interest: Overview, definition, and example
What is accrual of interest?
Accrual of interest refers to the process by which interest on a loan, deposit, or investment accumulates over time, regardless of whether it has been paid or not. This interest is calculated based on the principal amount (the original loan or investment) and the interest rate, and it typically accrues daily, monthly, or annually. The interest is added to the outstanding balance, and in many cases, it can also accrue interest itself (this is known as compound interest).
For example, if you have a savings account that earns 5% annual interest, the interest on your balance will accrue over time, even if you don’t withdraw or receive the interest until the end of the year.
Why is accrual of interest important?
Accrual of interest is important because it determines how much money will be earned or owed over time, and it helps track the financial impact of a loan, investment, or deposit. It ensures that interest is properly accounted for in financial statements, which is crucial for both individuals and businesses when assessing the growth of investments or the cost of borrowing.
For businesses, understanding the accrual of interest is necessary for budgeting, financial reporting, and compliance with accounting standards. For individuals, it helps in managing loans and investments effectively, ensuring they are aware of how much interest is accumulating and when it will be due.
Understanding accrual of interest through an example
Imagine you take out a loan of $1,000 with an interest rate of 6% annually. Over the course of one year, the loan will accrue $60 in interest, meaning the total amount owed at the end of the year will be $1,060. Even if the payment is not due for another year, the interest has already accumulated during that time.
In another example, if you invest in a bond that pays 4% annual interest, the interest will accrue throughout the year, but you may only receive a payment at the end of the year. Even though you haven't been paid yet, the interest continues to accrue on the bond's principal during that period.
An example of an accrual of interest clause
Here’s how an accrual of interest clause might appear in a loan agreement:
“Interest on the loan shall accrue daily at an annual rate of 5%, beginning on the date of disbursement and continuing until the loan is fully repaid. The interest will be added to the outstanding balance and shall be payable at the end of the term.”
Conclusion
Accrual of interest is the process by which interest on a financial obligation accumulates over time, whether it’s a loan, deposit, or investment. It plays a key role in determining the total cost of borrowing or the earnings from an investment. For businesses and individuals, understanding how interest accrues is crucial for financial planning, managing debt, and maximizing returns on investments.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.