What Is Gross Interest?
Let me explain gross interest directly to you: it's the annual rate of interest you'll see paid on an investment, security, or deposit account before any taxes or other charges get deducted. This is often the headline interest rate you encounter with fixed-income securities like bonds or CDs, loans, or deposit accounts.
I express gross interest as a percentage, and you can contrast it with net interest, which is what you actually earn after subtracting taxes, fees, and other costs. As a result, gross interest will always be higher than net interest.
Key Takeaways
- Gross interest is the headline interest rate earned on a fixed-income investment or paid on a loan before fees or taxes are accounted for.
- The gross interest rate is what is more often quoted for a loan or investment.
- Net interest deducts the impact of taxes, fees, and other costs from the gross interest. For instance, a gross 5% interest earned on deposits and taxed at 25% would result in 3.75% net interest.
Understanding Gross Interest
When you deposit money in your bank account, the bank pays you interest on those funds as compensation for letting them use it. They lend your deposit to other individuals or businesses, which generates income for the bank. Depending on the institution or account type, this interest might show up in your account monthly, quarterly, or annually.
We call this interest gross interest because it doesn't factor in taxes, which also affect your earnings. For example, if you have $3,000 in a savings account earning 2% interest paid yearly, that 2% is the gross interest. The bank would pay you $60 at year's end.
But remember, gross interest ignores other items like taxes, fees, and charges that apply to the account or investment. Once you deduct these, you end up with less. Building on the example, if there's a $5 annual fee and you're taxed at 35%, taxes would be $21 (that's $60 times 35%), and net interest would be $60 minus $21 minus $5, equaling $34, or 1.13%, which is less than the 2% gross interest.
Important Note
Gross interest is always higher than net interest.
Gross Interest and Bonds
Gross interest is simply the pure interest amount a debtor pays to a creditor. For bonds, the quoted interest income you receive as a bondholder is gross interest. Suppose you buy a $1,000 par value corporate bond with a 3% coupon rate payable annually, maturing in five years. The issuer pays you a fixed 3% on $1,000, which is $30, periodically over the bond's life. That fixed coupon rate is the gross interest.
However, at year's end, the government taxes the interest earned on that bond, so your effective net yield drops below 3%. You calculate net interest from gross after deducting other fees and costs. Keep in mind, yield includes total earnings like interest payments, and gross yield shows this return without subtracting expenses such as taxes and commissions.
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