What is the effective interest method?

The effective interest method, also known as the effective interest rate method, is a technique used for amortizing bonds. This method is based on the bond’s book value at the beginning of any given accounting period and reveals the actual interest rate in effect during any period in the bond’s life prior to maturity. The effective interest method can be a useful tool for investors purchasing a bond at either a premium or a discount to its face value — the amount of money an investor is owed when the bond reaches maturity. 

Investors are likely to pay a premium when a bond’s stated interest rate — listed on a bond coupon that does not factor in compounding — is higher than the current market rate. On the other hand, bonds will trade at a discount when the stated interest rate is lower than the current market interest rate.

On the other hand, bonds will trade at a discount when the stated interest rate is lower than the current market interest rate.

The effective interest method is an alternative to the straight-line method and is often the preferred technique, given its accuracy.

Why is the effective interest method important?

The effective interest method is essential due to its accuracy in reflecting the actual interest paid or earned over a certain period.It is considered an accurate method for determining the impact of an investment on an entity’s bottom line on a period-by-period basis. Due to its precision, it is more commonly used for the amortization of bonds versus the straight-line method.

How do you calculate the effective interest rate?

To calculate the effective interest rate, use the following formula. 

Effective interest rate = [(1+i/n)^n-1] x current book value

Note that, in this formula, “i” is the bond’s coupon rate, and “n” is the number of coupon payments to be made per year.

To simplify the calculation of the effective interest rate, consider using an online calculator. 

The effective interest rate vs. the stated interest rate

While both the effective interest rate and the stated interest rate — also known as the nominal interest rate — convey the interest rate on a financial security like a bond, there are several notable differences.

The effective interest rate shows the actual interest rate after taking into account compounding effects. Therefore, it reflects the actual annual return on an investment and is considered a more accurate determination of interest. The stated interest rate does not take compounding into account.

Unless the compounding period is exactly one year, the stated interest rate will be lower than the effective interest rate. For example, a bond has an annual interest rate of 5%, compounded annually. The stated interest rate of the bond is 5%, one compounding period each year, and a periodic rate of 5%. The effective interest rate is also 5%. In this scenario, if the 5% interest is compounded quarterly, versus annually, then the effective interest rate would be 5.095%. If compounded monthly, the effective interest rate would be 5.116%.

Stated interest rates are not always comparable unless they account for the same compounding period. However, different effective interest rates are comparable because effective interest rates consider compounding effects.

What is an example of the effective interest method?

If an investor sells or buys a financial instrument for an amount other than its face value, the interest rate they are actually paying or earning on the investment differs from the stated interest paid. To further explain, consider the following example.

Company A purchases a bond with a stated principal amount of $1,000. In three years, the issuer will pay off the bond. The bond has a coupon interest rate of 5%, which is paid at the end of each year. Company A acquires the bond for $900, a discount of $100 from the face value of $1,000. Company A classifies the investment as held-to-maturity since it intends to hold the bond until its maturity date versus selling it before then.

Based on a payment of $900 to purchase the bond, three interest payments of $50 each, and a principal payment of $1,000 upon maturity, company A obtains an effective interest rate of 8.95%. 

The following formula is used to calculate the effective interest rate. 

Effective interest rate = [(1+i/n)^n-1] x current book value

Note that, in this formula, “i” is the bond’s coupon rate, and “n” is the number of coupon payments to be made per year.

Using the effective interest rate, company A’s controller creates the amortization table for the bond discount.

With the amortization table, the controller records the following journal entries for each of the next three years.

Amortization table

How does the effective interest method differ from the straight-line method?

The effective interest method differs from the straight-line method in that it is considered far more accurate, from period to period. This method is also more complex to compute compared with the straight-line method.

Year 1 :

Year 2:

Year 3:

Journal entries

The effective method must be recalculated for every individual interest-earning period. The straight-line method charges off the same amount in each period. For this reason, the effective interest method is typically used when a bond is acquired at a significant discount or premium, or when the bond’s book value decreases or increases significantly during the life of the bond.

If a bond is purchased at face value, and the book value of the bond remains relatively stable throughout its life to maturity, the straight-line amortization method is acceptable and less work to compute. Either way, when the bond reaches maturity, the amounts amortized under the effective interest and straight-line methods will be the same.

Practical applications of the effective interest method

There are several practical applications of the effective interest method. These include, but are not limited to:

• Amortizing debt issuance costs.
• Amortizing interest expense associated with lease liabilities
• Calculating and recognizing the interest on loan portfolios

In short, the effective interest method can be more accurate when accounting for long-term contractual obligations.

This information was last updated on 04/30/2025.