The effective rate method spreads a discount, a premium, or a deferred fee across the periods of a loan or a debt instrument so that the interest recognized in each period is a constant percentage of the carrying amount at the start of that period. US GAAP calls it the interest method, and its objective is to arrive at periodic interest income, including the recognition of fees and costs, at a constant effective yield on the net investment in the receivable, meaning the principal amount adjusted by unamortized fees or costs and by purchase premium or discount (FASB Statement No. 91, paragraph 18).
What the Method Actually Computes
The rate is solved for once, and every later figure falls out of it. The difference between the periodic interest income determined at that constant effective yield and the stated interest on the outstanding principal amount is the amount of periodic amortization (FASB Statement No. 91, paragraph 18). Nothing about the size of a period’s amortization is a policy choice, which is what separates this method from one that divides an amount by a number of periods.
For a note or bond issued at a discount or premium the same mechanic is stated the other way round, as amortizing so as to produce a constant rate of interest on the amount outstanding at the beginning of each period, and the schedule that follows from it is worked through in bonds payable.
Where GAAP Requires It Beyond Bonds
Lending fees are the larger application, and most preparers meet the method there first. Loan origination fees are deferred and recognized over the life of the loan as an adjustment of yield, direct loan origination costs are deferred and recognized as a reduction in the yield of the loan except in a troubled debt restructuring, and the fee and the cost for a given loan are offset so that only the net amount is deferred and amortized (FASB Statement No. 91, paragraph 5). Those net fees or costs are then recognized by the interest method (FASB Statement No. 91, paragraph 18).
A purchased loan reaches the same place by a different route. The initial investment in a purchased loan includes the amount paid to the seller plus any fees paid or less any fees received, it frequently differs from the loan’s principal amount at the date of purchase, and that difference is recognized as an adjustment of yield over the life of the loan (FASB Statement No. 91, paragraph 15).
A Case Worked in the Standard Itself
The standard illustrates a ten-year loan originated at a stated rate, with a fee charged to the borrower and origination costs incurred, so the carrying amount starts below the principal and the effective rate sits above the stated rate.
Loan principal 100,000
Origination fee charged to the borrower (3,000)
Direct loan origination costs incurred 1,000
Carrying amount of the loan 98,000
Net fee deferred, the amount to amortize 2,000
Stated interest rate 10%
Ten equal annual payments 16,275
Rate equating those payments to 98,000, approx. 10.4736%
Year 1
Stated interest 100,000 x 10% = 10,000
Interest income 98,000 x 10.4736% = 10,264
Fee amortization 10,264 - 10,000 = 264
Principal repaid 16,275 - 10,000 = 6,275
Remaining principal 100,000 - 6,275 = 93,725
Unamortized net fees 2,000 - 264 = 1,736
Carrying amount 93,725 - 1,736 = 91,989Source: FASB Statement No. 91, paragraphs 65 and 66 and Table 1.
The net fee of 2,000 reaches interest income across the ten years and none of it is recognized at closing, because the practice of recognizing a portion of loan origination fees as revenue in a period to offset all or part of the costs of origination is no longer acceptable (FASB Statement No. 91, paragraph 5).
When the Stated Rate Is Not Constant
A loan whose stated rate moves during its term breaks the simple comparison, and the standard sets out three answers (FASB Statement No. 91, paragraph 18).
Where the stated rate increases during the term, interest accrued under the interest method in early periods would exceed interest at the stated rate, so interest income is not recognized to the extent that the net investment in the loan would rise above the amount at which the borrower could settle the obligation. Prepayment penalties count toward that settlement amount only to the extent they are imposed throughout the loan term.
Where the stated rate decreases during the term, the stated interest received early exceeds the interest income the method calculates, and that excess is deferred and recognized in the later periods when the constant effective yield exceeds the stated rate.
Where the stated rate varies with an independent factor such as an index, the constant effective yield is calculated either on the factor in effect at inception of the loan or on the factor as it changes over the life of the loan. Both are available, so the choice is a policy the file should record.
Prepayments Are Not Anticipated, With One Exception
The calculation uses the payment terms required by the loan contract, and prepayments of principal are not anticipated to shorten the loan term. The exception is narrow: where a lender holds a large number of similar loans for which prepayments are probable and the timing and amount can be reasonably estimated, it may consider estimates of future principal prepayments in calculating the constant effective yield (FASB Statement No. 91, paragraph 19).
Taking that option brings two obligations with it. When anticipated and actual prepayments differ, the lender recalculates the effective yield to reflect actual payments to date and anticipated future payments, then adjusts the net investment to the amount that would have existed had the new yield applied since the loans were acquired, with the offsetting charge or credit going to interest income. A lender that anticipates prepayments also discloses that policy and the significant assumptions underlying the prepayment estimates (FASB Statement No. 91, paragraph 19).
Where the Method Stops
Three situations take the loan outside it. Deferred net fees or costs are not amortized during periods in which interest income on a loan is not being recognized because of concerns about the realization of loan principal or interest (FASB Statement No. 91, paragraph 17).
For a loan payable at the lender’s demand, net fees or costs may be recognized as an adjustment of yield on a straight line basis over a period consistent with the understanding between borrower and lender, or with the lender’s estimate of how long the loan will remain outstanding, and any unamortized amount is recognized when the loan is paid in full. For a revolving line of credit the net fees or costs are recognized in income on a straight line basis over the period the line is active, assuming borrowings are outstanding for the maximum term the contract provides, and the interest method returns only once the agreement provides a payment schedule and allows no additional borrowings (FASB Statement No. 91, paragraph 20).
What the Effective Rate Method Is Not
An effective annual rate answers a different question. It converts a stated annual rate into what a year of that rate produces once interest compounds inside the year, which is a comparison between quotes rather than an allocation across periods, and the conversion is set out in effective interest rate formula.
An effective tax rate shares only the adjective, and it measures total tax for a period against a stated income measure, worked through in how to calculate effective tax rate.
Common Questions
They name the same mechanic. The US standards call it the interest method, practitioners and textbooks usually call it the effective interest method or the effective rate method, and all three describe one calculation: solve for the rate that equates the instrument’s cash flows to its carrying amount, apply that rate to the opening carrying amount each period, and let the difference against the stated interest be the amortization.
In two different ways, and only one of them is a judgment. For a discount or premium on a note, straight line is available where the results are not materially different from those the interest method would produce, which is a computation to run and keep in the file rather than a preference, set out in straight line amortization. For demand loans and revolving lines of credit the standard prescribes straight line directly, so no materiality test is involved.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a block of its own amortization schedules and loan fee work through a trial task before a client engagement depends on it.
