What is Interest on Investments?
Interest in investments is the periodic receipt of inflows on financial instruments, which may be like the bond, government securities, or bank account. It is income earned from the specified form of assets, which may be liquid. The pay-out can be monthly, quarterly, or annually. It is of utmost importance to keep track of the receipt of interest income. Over time, new models of money lending are getting evolved, along with that receipt of interest income is also getting modified accordingly.
Types of Interest on Investments
Following are the various type of interest on an investment that can be earned from different modes:
#1 – Interest from Bonds like Corporate Bonds, Secured Debentures, etc
Under this, the investor will get interested in bonds like debentures, corporate bondsCorporate BondsCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value.read more, certificates of deposits, etc. for the tenure of holding of respective financial instruments.
#2 – Bank Account like Saving Account, Current Account, etc
Under this, the account holder will get simple and compounding interestCompounding InterestCompound Interest is the interest earned from the initial Principal & the previously accumulated Interest amount. This is also known as “Interest on Interest” & it is always higher than the Simple Interest. read more on the balance in the accounts based on the days for which balance is available in the account.
#3 – Government Securities
Under this, an investor will invest in securities issued by various government departments and in the gilt bonds. Same as a corporate bond, here also investors will get interested based on the tenure of holding the financial instrument.
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For eg:
Source: Interest on Investments (wallstreetmojo.com)
Formula
Interest Income = P * R * N
Where,
- P= Principal
- R= Rate of interest
- N= Period
It is the formula for simple interest. Normally in the market for bonds and deposits with periodic payout are using the above formula. However, in deposits where the periodic payout is not available, their concept of compoundingCompoundingCompounding is a method of investing in which the income generated by an investment is reinvested, and the new principal amount is increased by the amount of income reinvested. Depending on the time period of deposit, interest is added to the principal amount.read more is used. In simple interestSimple InterestSimple interest is interest determined on a person's principal amount borrowed. It is determined by multiplying the principal amount borrowed by the interest rate and the time period for which interest is charged.read more, interest will be paid periodically, and then at the end principal will be repaid.
However, in compounding, periodic interest will be reinvested, and at the end of tenure, cumulative interest will be repaid along with the principal. Compounding is generally seen also in the mutual funds as well, where systematic investment plans are kept on getting invested and return on the same is getting accrued and reinvested.
Interest on Investments Examples
Below are the examples:
Example #1
ABC Limited invested $ 10,000 in the bonds of the Fed. The duration of the bond is 5 years. The rate of interest in the bond is 5 years.
You are requested to calculate:
- Interest income earned by ABC Limited
- The total amount that ABC Ltd will get back post maturity of the bond
Solution
- P= $ 10,000
- R= 5%
- N= 5 years
Calculation of interest earnings
= $ 10,000 * 5% rate of interest * 5 years
Interest earning will be –
- Interest-Earning = $ 2500
Amount = Principal + Interest
- Total Amount = $ 12,500
Thus, ABC limited will earn an interest of $ 2500 with investment in bond and will get back the total amount of $ 12,500 post maturity of the bond.
Example #2
Mr. Jackman invested $ 8,000 in bank deposits for 40 days with Deutsch Bank. The rate of interest on the deposit is 10 %. You are requested to calculate the interest income for Mr. Jackman.
Solution
- P= $ 8,000
- R = 10%
- N = 40 days
Calculation of interest earning
= $ 8,000 * 10% * 40 days / 365 days
Interest Earning will be –
- Interest Earning = $ 87.67
Thus, Mr. Jackman will earn $ 87.67 as interest from the investment in deposit
Advantages
- Fixed-Rate of Interest – One of the best advantages of interest incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. read more is that it gives steady earnings with a fixed rate for the specified period.
- Tax Saving Benefit – Interest income over government departmental bonds is tax exempted. Hence one can enjoy the benefit of earning the income and getting tax exemptionTax ExemptionTax-exempt refers to excluding an individual's or corporation's income, property or transaction from the tax liability imposed by the federal, local or state government. These exemptions either allow total relief from the taxes or provide reduced rates or charge tax on some items only.read more as well.
- Safe Mode of Earning – Earning interest income is one of the safest modes of earning in comparison to other investment options because of the risk profile of the investment.
Disadvantages
- Low Rate of Interest – As compared to other investment alternatives, interest-bearing securities give the least return because the rate is fixed and does not get increased with the passage of time and inflation effect.
- Charges and Fees – Many times, charges and fees are getting auto deducted from the account, and this levies financial charges. It gives a negative return to investors.
IFRS Requirement to Recognize Interest Income
As per IFRS 9, interest income will be recognized based on general or simplified approaches and Credit adjusted approach,
The detailed description is given below:
General or Simplified Approach
| Descriptions | No Evidence of Impairment Exists | Evidence of Impairment Exists | Credit Adjusted Approach |
|---|---|---|---|
| Interest income will be calculate on the basis of | Carrying value of the assets at the beginning of period | Carrying value of the assets at the beginning of period adjusted with credit risk | Carrying value of the assets at the beginning of period adjusted with credit risk |
| Rate of Interest that will be apply on the basis of | Effective Rate of Interest | Effective Rate of Interest | Effective Rate of Interest adjusted with credit risk |
The effective interest rateEffective Interest RateEffective Interest Rate, also called Annual Equivalent Rate, is the actual rate of interest that a person pays or earns on a financial instrument by considering the compounding interest over a given period.read more is the rate that discounts the all expected future cash outflows/inflows from the financial instrument at asset’s Amortized Cost preceding to any allowance for expected credit losses.
Conclusion
- Thus, interest income is a safe way of earning income from the financial instrument. It has the power to give perennial income at a fixed rate without any stoppage. Also, with time, many innovative models of investment have come. These also give the support of income with the effect of inflation as well.
- Interest income is one of a good source of income for income and corporates for safe income. In simple words, interest income is a good and safe source of income, even though the rate of interest is not so high.
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