What is Interest on Investments?
Interest on investments is the periodic receipt of inflows on financial instruments which may be in the nature of the bond, government securities or bank account. Basically, it is income earned from the specified form of assets which may be liquid in nature. The pay-out can be monthly, quarterly, or annually. It is of utmost importance to keep track of the receipt of interest income. With the passage of 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 bonds, 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 interest 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.
Formula
Where,
- P= Principal
- R= Rate of interest
- N= Period
This is the formula for simple interest. Normally in the market for bonds and deposits with periodic payout are using the above formula. However, deposits where the periodic payout is not available, their concept of compounding is used. In simple interest, 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 income is that it gives steady earnings with a fixed rate for the specified period of time.
- 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 exemption 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. This 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:
The effective interest rate 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. This has the power to give perennial income at a fixed rate without any stoppage. Also, with the passage of time, many innovative models of investment have come which gives also 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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