What Is an Effective Interest Rate Method?
The terminology used to explain an effective interest rate method assumes you know something (quite a bit actually) about accounting. You'll need to know the meaning of an effective interest rate. For simplicity, think of it as essentially the annual percentage rate charged for a loan. You'll also need to know a little accounting to figure out the different methods of amortizing the interest on a loan for tax purposes. One is straight-line amortization (the easiest), and the other is effective interest rate method (more complex). Lastly, a little bond knowledge is necessary.
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Bonds
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Usually when referring to the effective interest rate method (EIRM) of accounting it involves amortizing bond discounts or bond premiums. They're like two sides of a coin. When you buy a bond for $1,000, for example, the straight-line amortization allows you to subtract the $1,000 payment over the life of the bond (say 10 years) in equal amounts of $100 per year. That is subtracted from the interest paid by the bond, which fluctuates with the value of the bond. The EIRM, on the other hand, fluctuates annually as the value of the bond increases or decreases over the life of the bond. In other words, interest will decrease on the income statement when the value of the bond decreases. Conversely, bond interest expense on the income side of the ledger will increase as the bond value increases. More simply, you're balancing both sides of the ledger under EIRM while the straight-line measure doesn't take into account increases or decreases in bond value.
Balancing Your Checkbook
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Nobody likes balancing their checkbooks. But imagine if you knew every month you would spend exactly $1,000 and earn exactly $1,000. You'd be poor, but it's one check in and one check out. EIRM, on the other hand, is similar to real-life checkbook balancing. It keeps the income balance sheet in equilibrium with the expense balance sheet over the life of the bond premiums and discounts. It can get complicated but doesn't set off any flags with the IRS.
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Interest Rates
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Effective interest rates are easy to understand. If you take a one-year, $100 loan from a bank at 6 percent interest and pay it back in 12 equal installments over the year, you've paid $106. Discounted interest rates are slightly more complex but not much. Banks offer discounted loans, as well. You're thinking that's a good thing because it's a discount, but it's not. Here's why. Discounted loans subtract the interest payment from the principal before the balance is paid against the principal. The formula to determine the effective rate on a discounted loan is this: Interest/Principal minus Interest x 360/days the loan is outstanding. Using the example above, the effective rate on a discounted loan becomes $6 x $100 minus 360/number of days the loan is outstanding. So from Day One, the interest rate is 6.38 percent. Some discount. This is precisely why it becomes difficult to understand such things as EIRM; they are often the opposite of how we would construe them in everyday life.
Discounted Bonds
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Discounted bonds are bonds that are sold below their face value, thus the discount. They have no relationship with the market rate but attain their face value over the period of maturity. Regardless, using the EIRM, the interest expense will still correlate with the bond's book (market) value. This means that when a bond's book value decreases, the amount of interest expense will decrease, making the EIRM more logical than the straight-line method of amortizing bond premium.
Ignore the Bond Premiums
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For the average person and to simplify life and taxes for those who are checkbook-challenged, ignore the bond premium. The IRS allows this and it will simplify your taxes. If you ignore the premium, you will overstate the interest you will earn over the years you hold the bond. And unless the amounts are very significant, it only means that you will pay slightly more in income taxes on the bond interest over those years. In the end, you will show a capital loss on the bond equal to the premium. Even better, you can recover the final several years as an adjustment if you want to file amended tax returns using either the EIRM or straight-line method.
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References
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