What is the Effective Interest Method?
The Effective Interest Method is a technique used for amortizing bonds to show the actual interest rate in effect during any period in the life of a bond before maturity. It is based on the bond’s book value at the beginning of any given accounting period. The effective interest method calculation can be an important tool when an investor purchases a bond at either a premium or a discount to its face value (also known as par value).
Bonds are typically sold at a premium to their face value when the bond’s stated interest rate is greater than prevailing market rates. Investors are willing to pay a premium for the bond in order to secure higher interest income.
Conversely, bonds typically sell at a discount to their face value when the bond’s stated interest rate is less than prevailing market rates. The bond price must represent a bargain to compensate investors for the lower amount of interest that will be earned by holding the bond.
- The effective interest method is a technique used for amortizing bonds to show the actual interest rate in effect during any period in the life of a bond prior to maturity.
- It is useful when a bond is purchased at a significant discount or premium to its par value.
- The effective interest method is an alternative to the straight-line method of amortization.
How Effective Interest Rates on Bonds Fluctuates
If you buy a bond for any amount other than its face value, then the actual amount of interest that it will be earning will be somewhat different from the stated interest rate for the bond. For example, assume that you buy a bond issued by Company ABC with a par value of $1,000 and a stated interest rate of 5%, at a discount, paying only $950 for it. In such a case, the actual interest you will receive will be equal to 5.26% rather than 5%.
The effective, or actual, interest rate earned on a bond fluctuates in direct correlation to the bond’s book value. If the book value rises, then the interest earned rises as well. On the other hand, if the book value decreases, then the actual interest earned goes down, too. Therefore, the actual interest earned over the life of a bond to maturity can deviate significantly from the stated interest rate.
Why Use the Effective Interest Rate Method
The effective interest method of amortizing a bond is considered superior to the straight-line amortization method simply because it is more accurate, from period to period, than the straight-line method, under which the same amount is amortized during every period.
However, the effective interest method requires more work because it needs to be recalculated for every individual interest-earning period. Therefore, it is commonly only used when a bond is purchased at a significant premium or discount or when the bond’s book value increases or decreases significantly during the life of the bond.
For a bond purchased at face value, and where the book value of the bond remains relatively stable throughout its life to maturity, the straight-line amortization method works fine and is less difficult to calculate. In any event, when the bond reaches maturity, both the straight-line amortization and the effective interest rate method of calculating amortization will be equal.
Formula for Calculating the Effective Interest Rate
The formula used to calculate the effective interest rate is as follows:
- i = The bond’s coupon rate
- n = The number of coupon payments per year (i.e., if coupon payments are received monthly, then n would be 12)
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