Unearned interest is interest that has been collected on a loan by a lending institution but has not yet been recognized as income. Instead, it is initially recorded as a liability. If the loan is paid off early, the unearned interest portion must be returned to the borrower.
Inspiration Rooted Title: Understanding Unearned Interest on Loans
Unearned interest is also called unearned discount.
Distinguishing Earned from Unearned Interest
Interest recorded in the books of financial institutions is either earned or unearned. Earned interest is the interest income gained over a specified period from investments that pay the lender regular payments. For example, bonds generate earned interest through periodic interest payments to bondholders.
Unearned interest, however, has been collected but is not recognized as income and is initially recorded as a liability. Most lenders schedule loan payments at the beginning of the month. The interest paid by borrowers at the start of the month compensates lenders for providing funds throughout the month. For example, a borrower might make a $1,200 monthly payment with $240 covering interest. Since the interest at the beginning of the month has not been earned yet, it is recorded as unearned. This means an increase in the cash account and a credit to the unearned interest income account, illustrating that while the income is recorded, it is not yet considered earned.
If a loan is paid off early, the unearned interest portion must be returned to the borrower. For instance, if a borrower with a 36-month car loan repays it after 30 months, six months of unearned interest would be refunded, saving them this amount in the long run.
Inspirational Title: Amortizing Unearned Interest: Step-by-Step
Unearned interest is used in accounting methods by lending institutions for long-term, fixed-income securities. Initially recorded as a liability, it is slowly recorded as income as interest is earned over the loan’s life. This process is known as amortizing unearned interest.
When amortizing unearned interest, a portion of the unearned income is allocated to one period at a time, debiting the unearned interest income account and crediting the interest income account to balance the books.
Inspired Approach: Calculating Unearned Interest Simplified
Unearned interest can be calculated using the Rule of 78 for precomputed loans, where finance charges are calculated before the loan is made. This rule helps determine the finance charge or interest to be rebated if the loan is repaid early:
Unearned Interest = F x \[k(k + 1) / n(n + 1)\]
- Where F = total finance charge = n x M - P
- M = monthly loan payment
- P = original loan amount
- k = number of remaining payments
- n = original number of payments
Sample Calculation
A borrower takes a $10,000 loan to be repaid in 48 monthly installments of $310, but repays it after 36 months. The unearned interest can be calculated as follows:
- F = (48 x $310) - $10,000
- F = $4,880
- Unearned interest = $4,880 x \[12 x 13 / 48 x 49\]
- Unearned interest = $4,880 x (156 / 2352)
- Unearned interest = $4,880 x 0.0663
- Unearned interest = $323.67
By prepaying the loan, the borrower saves this unearned interest amount.
Related Terms: earned interest, prepaid interest, amortization, Rule of 78.
