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Interest Income

The amount paid to an entity for lending its money or letting another entity use its funds

What is Interest Income?

Interest income is the amount paid to an entity for lending its money or letting another entity use its funds. On a larger scale, interest income is the amount earned by an investor’s money that he places in an investment or project. A very simple and basic way of computing it is by multiplying the principal amount by the interest rate applied, considering the number of months or years the money is lent.

 

Interest Income

 

Where is the interest income presented?

Interest income is usually taxable income and is presented in the income statement for the simple reason that it is an income account. Usually, the two categories in the income statement, namely “Income from Operations” and “Other Income” are listed separately. In such an instance, the presentation of interest income will largely depend on the nature of the business’ primary operations.

If, for example, the income from interest is a major source of funds for the company, then it falls under “Income from Operations.” If it is not a primary revenue source, then it is classified as “Income from Investments” or “Other Income.”

 

Example of interest income

A very simple example of interest income that happens every day is when an individual deposits money into a savings account and decides to leave it untouched for several months or years. The money won’t just sit idly in his account, because the bank will use it to lend money to borrowers. The bank will earn interest by lending money out, but will also pay interest to holders of deposit accounts.

At the end of every month, the account statement will reflect the interest that the bank pays for borrowing the account holder’s money. It is important to note that banks use what is called “fractional banking,” which means that only a part of customer deposit accounts can be used by the bank as lending funds. The bank must retain a certain level – known as the reserve – of deposit account funds. It cannot legally loan out all the funds that customers have deposited with it.

 

Interest income vs. Interest expense

The main difference between interest income and interest expense is outlined below:

  • Interest income is money earned by an individual or company for lending their funds, either by putting them into a deposit account in a bank or by purchasing certificates of deposits.
  • Interest expense, on the other hand, is the opposite of interest income. It is the cost of borrowing money from financial institutions, banks, bond investors, or other lenders. Interest expense is incurred in order to help a company fund its operations, such as the purchase of additional machinery, plant, and property, or the acquisition of competitors or other companies.

In some cases, businesses report the interest expense and interest income separately, while others combine them and label them as “Interest Income – Net” or as “Interest Expense – Net.”

 

Interest income vs. Dividend income

Interest income is not the same as dividend income. The former is an amount earned for letting another person or an organization use one’s funds, while the latter is an amount that comes from the company’s profits and that is paid to the organization’s equity shareholders and preferred shareholders.

 

How to compute interest income

Simple interest can be computed in very simple steps. Let’s look at the process below:

  1. Take the annual interest rate and convert the percentage figure to a decimal figure by simply dividing it by 100. For example, an interest rate of 2% divided by 100 is 0.02.
  2. Use the decimal figure and multiply it by the number of years that the money is borrowed. For example, we can multiply 0.02 by 3 years and get 0.06.
  3. Multiply that figure by the amount in the account to complete the calculation. Let’s say the principal amount borrowed is $5,000; multiplying the figure by 0.06 will give us $300. Thus, $300 is the interest earned for the money lent for a period of 3 years.

 

Final word

Interest income is one of the many sources of income for businesses and individuals. Simply putting some money in the bank is a good way to start earning interest, although the interest rate for a standard savings account is not very high.

 

More resources

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

  • Annual Percentage Rate (APR)
  • Effective Annual Interest Rate Calculator
  • Expected Return
  • Federal Deposit Insurance Corporation (FDIC)

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