Understanding Accrued Interest


August 22, 2011

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Using the same example bond for sale from the previous chapter, we want to illustrate the concept of accrued interest.

Accrued interest is calculated anytime you are purchasing a bond in the market other than at the time of original issuance. The concept is easy to understand. Even though $250 is only paid every six months on March 1 and September 1, the bond is always earning interest on a daily basis. For instance, let’s say someone buys the bonds on February 25th; within a few days, the buyer would collect an interest payment of $250 on March 1. To offset this factor for the seller, on whatever day you are buying the bonds, you will be expected to pay all of the interest that the bond has accumulated since the previous interest payment up to the date of your purchase this is known as accrued interest. So if you buy a bond on November 30, right before the 3-month anniversary, since the last interest payment was made on September 1, you will have to pay 90 days worth of interest or $125 in accrued interest to the seller. 3 months of interest was accrued from September 1 to November 30. On March 1, within 3 months, you will collect the full six-months interest of $250.

Another way to think about accrued interest is this: Let’s say you are buying a car. You and the seller agree to a fixed price + the value of the gas in the tank. The gas in the tank is similar to accrued interest. It is how much interest was earned while the previous owner owned the bonds, but has not been paid to him since you are buying the bonds prior to the next interest payment. Anyone selling you bonds will automatically calculate this for you.

Don’t worry. The dealer, the seller, or you do not have any discretion in how accrued interest is computed. It is an objective calculation that follows securities industry rules.

 

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