What it means
Interest due builds up day by day on the outstanding balance and crystallises at the end of each billing period. On a monthly facility, the interest due on the payment date covers only the days since the last payment, which is why a February payment is usually smaller than a March one on the same loan.
The amount depends heavily on the day count convention. A 30/360 basis treats every month as thirty days and every year as 360, whereas actual/365 counts real days, and the two produce different figures on the same loan at the same rate.
When a payment is made, it is applied first to interest due and only then to principal. This is why early payments on an amortising loan barely dent the balance while later payments make rapid progress: the interest due shrinks as the principal falls.
Unpaid interest does not simply disappear. Depending on the agreement it either sits as arrears attracting a default rate, or it is added to the principal, which is capitalisation and means the borrower starts paying interest on interest.
In the accounts, interest due at a reporting date sits as an accrued liability if it has not yet been paid. Finance teams reconcile this figure to the lender's statement every month, because a mismatch usually means a rate change, a fee or a missed payment has not been recorded.
In practice
Real-world examples.
Example
A retailer receives a bank statement showing $12,400 of interest due on its overdraft for the quarter. The finance manager reconciles it to the daily balances and finds the bank applied the unauthorised rate for four days, then recovers $900.
Example
A borrower makes an extra $20,000 payment mid-month. Because interest due is calculated daily, the overpayment reduces the balance immediately and cuts the interest due at the next payment date by roughly $108.
Example
A company in a covenant breach negotiates a three-month payment holiday. Interest still becomes due each month and is added to the principal, so the balance grows by around $7,800 over the holiday even though no cash leaves the business.
Formula
Calculation
Interest due = Outstanding principal x Annual rate x (Days in period / Day count basis).
A business has a loan with an outstanding principal of $480,000 at an annual rate of 6.5%, and makes a fixed monthly payment of $6,000.
Annual interest at that balance = $480,000 x 0.065 = $31,200.
On a 30/360 basis, the monthly interest due = $31,200 / 12 = $2,600.
The payment of $6,000 is applied to the $2,600 of interest due first, leaving $6,000 - $2,600 = $3,400 to reduce principal. The new balance is $480,000 - $3,400 = $476,600, and next month's interest due will be slightly lower.
Now compare the day count. On an actual/365 basis for a 31-day month, interest due = $480,000 x 0.065 x (31 / 365) = $2,649.86. That is $2,649.86 - $2,600.00 = $49.86 more than the 30/360 figure for the same month, which over a year of long months is a real difference worth checking in the loan agreement.Case study
Seen in the real world.
Delacourt Property Partners is a fictional landlord created for this illustrative example. It held a $4,000,000 development loan at 9% on an interest-only basis, with interest due quarterly, and the site was running six months behind schedule.
Facing a cash squeeze, the managing partner asked the lender to roll up two quarters of interest rather than pay it. The lender agreed, and the interest due of $4,000,000 x 0.09 x (6 / 12) = $180,000 was capitalised into the principal, taking the balance to $4,180,000. Interest for the following quarter was then charged on the larger balance, at $4,180,000 x 0.09 / 4 = $94,050 instead of $90,000.
Delacourt had treated the roll-up as free breathing space, and in cash terms for that period it was. Over the eighteen months to completion, though, capitalisation added roughly $47,000 of extra interest and pushed the loan-to-value ratio close to its covenant limit. This illustrative case shows that deferring interest due changes the size of the debt, not just its timing.
Watch out
Common mistakes.
- Assuming a fixed monthly payment is all interest or all principal, when it is split, with interest due taken first and only the remainder reducing the balance.
- Ignoring the day count convention in the loan agreement, so budgeted interest is consistently understated on 31-day months under an actual/365 basis.
- Treating a payment holiday as free, when interest continues to become due and is usually capitalised into the principal.
Questions
People also ask.
What is the difference between interest due and interest accrued?
Accrued interest is the amount earned so far in a period, while interest due is the amount that has become payable at a specific date under the agreement.
What happens if interest due is not paid on time?
The lender usually applies a default rate to the arrears, and persistent non-payment can trigger a covenant breach or make the whole loan repayable.
Does an early repayment reduce the interest due?
Yes on a daily-accruing facility, because the balance falls immediately, though some fixed-rate loans charge a break fee that offsets the saving.
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