Accrued Interest

Accrued interest is the interest that has accumulated on a debt since the last date interest was paid, and that is owed but not yet due. The SEC's investor glossary defines it from the holder's side as "Interest earned on a security but not yet paid to the investor." The MSRB's fuller definition describes the bond-market measurement: "The dollar amount of interest, based upon the stated rate of interest, that has accumulated on a security from (and including) the most recent interest payment date (or, in certain circumstances, the dated date or other stated date), up to but not including the date of settlement of a transaction in such security."

The concept is the same on both sides of a loan. A bond investor earns interest every day and is usually paid it twice a year; a borrower incurs interest every day and usually pays it monthly. In between, the amount that has built up is accrued interest in either case. What differs is what happens to it: on a bond it is settled between buyer and seller when the bond trades; on a loan it is cleared by the next payment, or, if it is not paid, it may be added to the balance.

Bonds trade with accrued interest attached. A bond pays its coupon to whoever owns it on the payment date, so a buyer who takes a bond two months into a six-month coupon period will receive the full six months of interest at the next payment date even though they earned only four. The market fixes this at settlement: the buyer pays the seller the interest accrued from the last coupon date up to, but not including, the settlement date, as the MSRB's definition describes, and the MSRB notes that "Accrued interest is paid to the seller by the purchaser." The quoted price of a bond, sometimes called the clean price, excludes this interest. The total the buyer actually pays, sometimes called the dirty price or full price, is the clean price plus accrued interest. Neither term is regulatory vocabulary, but both appear on trade confirmations and in market commentary, and a buyer comparing a quoted price with a settlement amount will meet the difference immediately.

The starting point for a new issue is the dated date. The MSRB defines the dated date as "The date from which interest on a new issue of municipal securities typically starts to accrue." A bond that settles after its dated date already carries accrued interest on the first day it is owned, which is why a new-issue buyer can be charged accrued interest before any coupon has been paid.

The day count is a convention, and it is not the same everywhere. The MSRB's definition continues: "Accrued interest is usually calculated on the basis of a 360-day year (assuming that each month has 30 days), but alternative day counting methods (most commonly based on a 365- or 366-day year counting actual days elapsed) are used for many securities that bear interest at a variable rate and for certain other types of securities (e.g., some municipal notes)." Its formula for the 30/360 convention is the interest rate multiplied by the par value multiplied by the number of days over 360. The convention matters only at the margin, but it explains why two people computing accrued interest on the same bond can arrive at slightly different figures.

The tax follows the economics: the seller earned it, so the seller is taxed on it. Publication 550 states the rule for both parties. For the seller: "If you sell a bond between interest payment dates, part of the price represents interest accrued to the date of sale. You must report that part of the sales price as interest income for the year of sale." For the buyer, the coupon that later arrives includes money that was really a return of the accrued interest paid at purchase, and the IRS provides one reporting mechanic for it. Under the heading "Accrued interest on bonds," Publication 550 instructs: "If you received a Form 1099-INT that reflects accrued interest on a bond you bought between interest payment dates, include the full amount shown as interest on the Form 1099-INT on Schedule B (Form 1040), Part I, line 1. Then, below a subtotal of all interest income listed, enter "Accrued Interest" and the amount of accrued interest you paid to the seller. That amount is taxable to the seller, not you. Subtract that amount from the interest income subtotal." The Schedule B page lists that subtraction among the adjustments the form allows; this is the event that produces it. The same publication notes, in its discussion of bonds bought between interest dates, that the effect is to treat the recovered accrued interest as a return of the buyer's capital, so the buyer's reported interest and the buyer's economic interest end up equal.

On a loan, accrual runs daily and payments clear it first. A simple-interest loan accrues interest each day on the outstanding principal, and each payment is applied to the interest that has accrued since the last payment before any of it reduces principal. The simple interest and loan principal pages carry the arithmetic. Two consequences follow. A payment made late carries more accrued interest and therefore retires less principal. And when payments are suspended, as during a student loan deferment or forbearance, the interest does not stop; it accrues, and if it is still unpaid when payments resume it may be added to the principal balance, after which interest is charged on the larger figure. That addition is capitalization, and the student loan interest capitalization page covers when it happens.

On a deposit, accrued is not the same as credited. A savings account may accrue interest daily and credit it to the balance monthly. Until the credit date the accrued interest is owed to the depositor but not yet in the account, and the compounding frequency page explains the disclosure that governs what happens to it if the account is closed first.

On a bond. The buyer and seller agree a price. The broker computes the interest accrued from the last coupon date (or the dated date, for a new issue) to the settlement date under the bond's day-count convention, and adds it to the amount the buyer pays. On the next coupon date the buyer receives the full coupon. At tax time the seller reports the accrued interest received as interest income; the buyer reports the full coupon and subtracts the accrued interest paid.

A hypothetical example. Owen buys $10,000 face value of a bond with a 4 percent coupon paid semiannually, so each coupon is $200. The trade settles 60 days after the last coupon date, and the bond accrues on a 30/360 basis. Accrued interest is 4% × $10,000 × 60 ÷ 360 = $66.67. If the quoted price is $9,900, Owen pays $9,900 + $66.67 = $9,966.67.

Four months later Owen receives the full $200 coupon. His Form 1099-INT for the year shows $200 from this bond. On Schedule B he lists the $200, then below the subtotal enters "Accrued Interest" with $66.67 and subtracts it, so he is taxed on $133.33, the interest he actually earned. The seller reports the $66.67 as interest income for the year of the sale. Between them, $200 of interest is taxed once.

On a loan. Interest accrues daily on the outstanding balance. When a payment arrives, the servicer applies it first to the accrued interest and then to principal.

A hypothetical example. Mara owes $20,000 on a loan at 6 percent simple interest, accruing daily on a 365-day year. Daily interest is $20,000 × 0.06 ÷ 365 = about $3.29. After 30 days, accrued interest is about $3.29 × 30 = $98.63. Her $400 payment clears the $98.63 of accrued interest first and reduces principal by $400 − $98.63 = $301.37, leaving a balance of $19,698.63. Had she paid 45 days after the previous payment instead, the accrued interest would have been about $147.95 and the same $400 would have reduced principal by only $252.05.

Pros

• Settling accrued interest between buyer and seller means a bond can be sold on any day without either party losing or gaining interest they did not earn.
• The IRS mechanic on Schedule B puts the tax where the income went, so a buyer is not taxed on the seller's interest.
• On a loan, knowing that a payment clears accrued interest first explains why paying a few days early or making an extra mid-month payment retires more principal.
• Daily accrual is transparent: the borrower's payoff figure on any day is the principal plus the interest accrued to that day.

Cons

• A bond's quoted price understates the cash a buyer needs at settlement, sometimes by several months of interest, which surprises first-time buyers.
• The buyer receives a Form 1099-INT for the full coupon and must make the Schedule B subtraction themselves; missing it means paying tax on the seller's income.
• Day-count conventions differ between securities, so accrued interest figures from two sources can disagree by a small amount.
• On a loan, accrued interest that goes unpaid during a deferment or forbearance does not disappear, and on many loans it is eventually capitalized, after which interest accrues on interest.