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The interest method is a specific method used to determine interest income or interest expense. This method is primarily used by investors to analyze a bond discount or premium. It can also be used by creditors to calculate interest paid. Those who use the interest method of calculating interest do a calculation at the beginning of the accounting period. This calculation involves multiplying the carrying value of the debt or receivable by the effective interest rate.
The carrying value of the debt or receivable is the amount of money that interest is currently being assessed on. If, for example, a creditor has a client who owes him $100,000 US Dollars (USD) at the beginning of the accounting period, the carrying value is $100,000 USD; it is a receivable, since it is money owed. If the debtor pays off $1000 USD in principal during the course of the accounting period, then the next time the interest is assessed, the carrying value is equal to $99,000 USD.
The interest method is often considered a preferable method of calculating interest income and expenses since it allows a fixed interest rate to be charged but different dollar amounts to be charged each period. For example, the interest rate on the above $100,000 USD debt may be 6% per year. Instead of simply charging $6,000 USD in interest per year, the 6% annual interest rate is applied to the actual balance owed to determine the effective interest rate.
The accounting period in which the interest method is used to calculate the interest expense can vary depending on the creditor and the situation. Most commonly, the accounting period is monthly and thus the interest is calculated and varies from month to month. On the other hand, if payments are made quarterly or biannually, the accounting period can be quarterly or biannually and the interest rate and interest expense or income will thus be calculated quarterly or biannually.
The interest method can be used to determine how much an investor is actually making on a bond or other investment. He can calculate the effective interest rate — the interest he is actually earning — using these figures because it allows him to see how his interest balance, when added to the principal, affects his rate of return. For example, if an investor invests a starting balance of $10,000 USD at 5% interest, he can determine both how much interest that starting balance will earn in the first month, and then by adding the earned interest to the original balance and multiplying that by the interest expense the following month, he can determine how much additional income he has as a result of compound interest.
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