Unearned Interest

What Is Unearned Interest?

Unearned interest will be interest that has been collected on a loan by a lending institution yet has not yet been recognized as income (or earnings). All things considered, it is initially recorded as a liability. In the event that the loan is paid off ahead of schedule, the unearned interest portion must be returned to the borrower.

Unearned interest is additionally called unearned discount.

BREAKING DOWN Unearned Interest

Interest kept in the books of financial institutions because of lending activities is either earned or unearned. Earned interest, as the name suggests, is interest income that is earned over a specific period of time from investments that pay the lender an ordinary series of commanded payments. Interest earned can be produced from bonds through interest payments made to bondholders after a stated period of time.

Unearned interest has been collected yet isn't recognized as income (or earnings). It is initially recorded as a liability.

Not all interest that is received by a lender is earned. Most lenders schedule loan payments to be made toward the beginning of the month. The interest paid by borrowers to remunerate lenders for lending them funds for a predetermined period of time addresses interest income to the lender. In any case, the interest paid by the borrower toward the beginning of the month applies to the cost of borrowing all month long and, in this manner, has not been earned by the lender. For instance, expect a borrower, on the first of every month, makes his customary $1,200 payment on a loan of which $240 is the interest portion. The $240 is the borrower's cost for utilizing the loan all month long. Since he prepaid the interest, the $240 won't be earned by the lending institution in light of the fact that the principal of the loan has not been outstanding long enough. To perceive this transaction, the cash account is charged (increase in cash) and the unearned interest income account on the ledger is credited. This shows that the bank records such income however perceives the interest portion as unearned.

In the event that the loan is paid off ahead of schedule, the unearned portion must be returned to the borrower. For instance, expect a borrower requires out a three year loan on a vehicle. In the event that she pays off the whole loan following 30 months, she will be refunded 6 months interest unearned. This is the amount she will save by paying off the loan early.

Amortization of Unearned Interest

Unearned interest is an accounting method utilized by lending institutions to deal with long-term, fixed-income securities. Initially recorded as a liability, the unearned interest will eventually be recorded as income in the lending institution's books over the life of the loan over the long haul and the interest is earned. This accounting system is alluded to as amortizing unearned interest.

While amortizing unearned interest, a portion of the income is allocated to each period in turn. To amortize prepaid interest, the unearned interest income account is charged and the interest income account is credited.

Computing Unearned Interest

Unearned interest can be estimated utilizing a method known as the Rule of 78. The Rule of 78 deals with precomputed loans, that is to say, loans which have their finance charges calculated before the loan is made. The Rule of 78 is utilized to compute the amount of the finance charge or interest to be refunded if the loan is repaid early. The formula for unearned interest is:

Unearned interest = F x [k(k + 1)/n(n + 1)]

where F = total finance charge = n x M - P

M = customary month to month loan payment

P = original loan amount

k = staying number of loan payments after current payment

n = original number of payments

For instance, a borrower takes a $10,000 loan on a vehicle to be repaid in 48 regularly scheduled payments of $310.00. In any case, she repays the loan following 36 months. The lender's unearned interest can be calculated to be:

F = (48 x $310) - $10,000

F = $4,880

Unearned interest = $4,880 x [(12 x 13)/(48 x 49)]

Unearned interest = $4,880 x (156/2352)

Unearned interest = $4,880 x 0.0663

Unearned interest = $323.67