What Is Unearned Interest?
Let me explain unearned interest directly: it's the interest a lending institution collects on a loan but hasn't yet recognized as income or earnings. Instead, you record it initially as a liability. If you pay off the loan early as a borrower, that unearned interest portion has to be returned to you.
You might also hear it called unearned discount.
Breaking Down Unearned Interest
When we look at interest in the books of financial institutions from lending, it's either earned or unearned. Earned interest is what it sounds like—interest income earned over a specific period from investments that pay out regular mandated payments. This can come from bonds, for instance, through interest payments to bondholders after a set time.
Here's what's important: unearned interest has been collected but isn't recognized as income or earnings yet—it's initially a liability.
Not all interest a lender receives is earned right away. Most lenders set loan payments at the beginning of the month. The interest borrowers pay compensates lenders for the funds lent over a specified period, representing interest income. But interest paid at the month's start applies to the whole month's borrowing cost, so it hasn't been earned by the lender yet. Take this example: suppose you, as a borrower, make a regular $1,200 payment on the first of each month, with $240 as the interest portion. That $240 covers your cost for using the loan the entire month. Since you prepaid it, the $240 isn't earned by the institution because the principal hasn't been outstanding long enough. To handle this, the cash account gets debited for the increase in cash, and the unearned interest income account is credited. This way, the bank records the income but marks the interest as unearned.
If you pay off the loan early, the unearned portion goes back to you. For instance, if you take a 36-month car loan and pay it off after 30 months, you'll get refunded for 6 months of unearned interest. That's the savings from early payoff.
Amortization of Unearned Interest
Unearned interest is an accounting method lenders use for long-term, fixed-income securities. You start by recording it as a liability, but over the loan's life, as time passes and interest is earned, it gets recorded as income. This process is amortizing unearned interest.
When amortizing, you allocate a portion of the income to each period. To amortize prepaid interest, debit the unearned interest income account and credit the interest income account.
Calculating Unearned Interest
You can estimate unearned interest with the Rule of 78, which applies to precomputed loans—those with finance charges calculated before the loan starts. The Rule of 78 calculates the finance charge or interest to rebate if the loan is repaid early.
Formula for Unearned Interest
- Unearned interest = F x [k(k + 1) / n(n + 1)]
- Where F = total finance charge = n x M – P
- M = regular monthly loan payment
- P = original loan amount
- k = remaining number of loan payments after current payment
- n = original number of payments
Example Calculation
Consider this: you take a $10,000 car loan to be repaid in 48 monthly installments of $310.00, but you repay it after 36 months. The lender's unearned interest calculates as follows: F = (48 x $310) - $10,000 = $4,880. Then, unearned interest = $4,880 x [(12 x 13) / (48 x 49)] = $4,880 x (156 / 2352) = $4,880 x 0.0663 = $323.67.
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