What Is an Unearned Discount?
Let me explain what an unearned discount is. It's essentially an interest or fee collected on a loan by a lending institution, but you don't count it as income right away. Instead, you record it as a liability initially. As the loan goes on, you take proportionate parts of that upfront fee or interest and move them from the liability side of the balance sheet to count as income. If the borrower pays off the loan early, you have to return the unearned interest portion to them.
You'll often hear unearned discount referred to as unearned interest—it's the same thing.
Key Takeaways
Here's what you need to know directly: Unearned discount is loan interest that's been collected but isn't recognized as income yet. You record it as a liability and convert it gradually into income as the loan matures. Remember, it's more commonly called unearned interest.
Understanding Unearned Discounts
You should understand that an unearned discount account handles interest deductions before they're classified as earned income over the debt's term. Over time, this unearned discount boosts the lender's profit while reducing the liability.
Not all interest a lender receives is 'earned' immediately. Lenders often schedule payments at the start of each month, but that interest covers the whole month, so it's unearned when prepaid. For instance, if a homeowner has a mortgage with a $1,500 monthly payment on the 1st, including $500 in interest, that $500 covers the entire month and is unearned on day one. As the month goes by, you credit a pro-rata amount to the bank's earnings, shrinking the unearned discount liability.
Calculating an Unearned Discount
When you need to calculate unearned discounts, especially for loans with precomputed finance charges, you can use the Rule of 78. This method figures out the unearned discount if the loan is repaid early or refinanced. The formula is: Unearned discount = F [k (k + 1) / n (n + 1)], where F is the total finance charge (equal to n x M – P), M is the regular monthly loan payment, P is the original loan amount, n is the original number of payments, and k is the number of remaining payments after the current one.
Example of Unearned Discount
Consider this example to see it in action. Snuffy's Bank and Trust issues a $10,000 loan to Ernie's Brokerage, repayable over 5 years in monthly installments, with a 6% upfront finance charge of $600. Initially, the bank records this $600 as a liability. As Ernie makes each of the 60 payments, you remove 1/60th of the $600 from the liability and recognize it as income on the balance sheet.
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