What is the effective interest rate?

The effective interest rate is the true rate of interest earned. It could also be referred to as the market interest rate, the yield to maturity, the discount rate, the internal rate of return, the annual percentage rate (APR), and the targeted or required interest rate.

For example, a $1,000 bond that promises to pay 5% interest is said to have a stated, contractual, face, or nominal interest rate of 5%. This means that the corporation will pay exactly $50 per year during the life of the bond and the principal amount at maturity. If the market interest rates increase by one percentage point, the 5% bond becomes less attractive and will drop in value because the bond contract states that the corporation will pay $50 per year for the life of the bond–even in a 6% market. New investors will purchase the 5% bond in a 6% market only if they will earn 6% interest over the life of the bond. To arrive at the price they will pay for a bond paying only $50 per year in interest, the investors and the market will discount the future cash flows by 6% to arrive at the present value. (In other words, the $50 per year annuity will be discounted by 6% and the $1,000 at maturity will be discounted by 6%. The combination of the present value of the annuity and the present value of the maturity amount is the amount that will provide an investor with exactly a 6% return over the remaining life of the bond.) This is why the effective rate is also referred to as the discount rate, the market interest rate, the yield to maturity, the internal rate of return on the investment, the targeted rate, or required rate of return.

The preferred way to amortize the premium or discount on bonds payable is through the use of the effective interest rate. The effective interest rate will be multiplied times the carrying value of the bonds in order to determine the bond interest expense. The difference between this expense and the cash interest payment is the amount amortized.

You can learn more about the present value computations by reading Present Value of 1 and Present Value of an Ordinary Annuity on www.AccountingCoach.com. You can learn more about the effective interest rate method of amortization by reading about that topic in an intermediate accounting textbook.

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