What Is Accrued Interest?
Every mortgage payment is made up of two parts. The first cost that your repayment covers is the principal, or the original balance you borrowed. The second portion goes toward your loan’s interest. But while every homeowner must pay interest on their loan, interest can still function differently for each borrower.
During your loan shopping, one term you may encounter is “accrued interest.” But what is accrued interest, and how does it impact you? Here’s how accrual functions and ways you can calculate it for yourself.
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Accrued Interest: Definition
When you take out a personal loan or a mortgage, you’re charged interest for the service. This interest rate depends on the principal amount you borrowed. But accrued interest is a specific part of your interest.
Accrued interest is the amount of interest that has grown on the loan but has not been paid out yet by a certain date. Accrued interest is incurred as an expense for the borrower and revenue for the lender.
Accrued interest gets calculated at the end of the loan’s accounting period.
How Does Interest Accrue On A Mortgage?
Interest goes hand in hand with home loans. But prospective borrowers should know how various types of accrual work. Here are some of the ways interest accrues on a home loan.
Usually, lenders calculate interest based on a monthly schedule. When they do, your interest builds on a monthly basis. It repeats the accrual process each monthly period based on the new loan principal balance.
To find the amount you would pay in interest for this accrual method, you start with your yearly mortgage interest rate. Then you divide that rate by 12 and apply it to your initial mortgage balance.
Generally, a mortgage will come with large interest charges at the start of repayment. That’s because your principal is at its largest. However, your interest charges will gradually shrink as you pay down your mortgage over time. After that, more of your monthly payment will go to your principal.
Annual Percentage Yield
Annual percentage yield (APY) is another interest rate you will encounter. It’s the measure of your loan’s annual cost, including compounded interest. In some cases, your lender will provide both the mortgage interest on your loan and the APY.
If you want to find your annual interest, you need to divide your interest rate compounded over 12 months.
When your interest accrues on a daily basis, small amounts of interest add to your account balance each day. Daily interest is generally rare in the case of mortgages, though. You’re much more likely to see daily interest accrual with credit cards.
Regardless, daily accrual is essentially your mortgage interest rate divided by 365. This rate stays consistent throughout the same month and applies at the end of the month. The overall amount varies depending on how many days are in the month. So, for example, you’ll probably pay more in March than in February, which is a shorter month.
How To Calculate Accrued Interest
Accrued interest is calculated a couple different ways depending on the type of debt. With a mortgage, accrued interest accounts for unpaid interest. We’ll lay out a formula and example here of monthly interest payment for a mortgage.
The way most mortgages are paid, you pay more interest upfront and less over the length of the loan. As the mortgage amortizes, more of your payment will go toward the principal. Here’s a formula your lender will use to determine how much interest is paid each month:
- (Principal owed x interest rate) / 12 = monthly interest
Let’s use this in an example. Say you take out a 30-year fixed-rate mortgage of $400,000 at a rate of 5%. You make your first payment in April. Not including taxes, insurance and other fees, this puts your monthly payment at $2,147.
To determine how much of that payment is interest, take $400,000 and multiply it by 0.05. The result is $20,000, which divided by 12 gives you $1,667 in interest for that month. By subtracting that from the total payment of $2,147, you find that you paid $481 towards your principal.
That means in May, the balance you have is $399,519. The same formula repeats for your May payment. Because you paid down a portion of your principal, the amount of interest charged on it for May is smaller: $1,665. While it’s only a $2 difference, over time you chip away at your principal and your monthly payment is less comprised of interest.
The Bottom Line
Interest varies depending on the type of loan and lender you choose. Even so, it’s important for borrowers to understand how interest plays into their mortgage. You can prepare for your potential interest costs when you know how your lender calculates accrued interest.
These estimates can not only inform prospective first-time borrowers but current homeowners as well. If you want a lower rate, consider refinancing your mortgage. Shop around for competitive rates and see which one would fit into your finances.
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