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What is interest income?
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What Is Interest Income
Interest income represents an amount of money received by a lender for lending funds to a borrower for a certain period of time.
In other words, an individual, business, financial institution, or entity who lends out money to another person or entity for a fee receives interest as a source of income.
The term “interest” is defined as an amount of money that is paid by someone who uses borrowed money.
According to Investopedia, interest is defined as:
Interest is the monetary charge for the privilege of borrowing money, typically expressed as an annual percentage rate (APR).
In other words, it’s a financial charge or fee paid by someone who has been given the privilege to use another person’s money.
The term “income” means a source of revenue to a person or entity.
You can earn an income from providing services, selling goods, or earning money through investments.
An investor will earn an income through investments whereas a company earns an income through different sources like business revenues, investment income, and other.
Now that we know what interest and income mean, we can conclude that interest income represents a source of revenue to a company or person coming from the process of lending out money for a fee.
For example, imagine that you borrow some money from the bank to purchase a real estate property.
You will sign a deed of mortgage where the bank agrees to lend you a certain amount of money in exchange for you to pay interest on the principal.
For the bank, the interest that you will pay will represent interest income.
When the bank deducts all the expenses it incurs from its gross interest, it can derive its net interest income.
Another example is when you put your money in a savings account, certificate of deposit, or bonds.
In this case, you are the investor or lender giving money to the bank or a company in exchange for a fee representing the interest you earn on your savings account, CD, or bonds.
Interest Income vs Interest Expense
What are the differences between interest income and interest expenses?
Interest income or total interest income represents the amount of money charged by a lender or investor to let a borrower use a certain amount of money, at a certain rate of interest, for a certain period of time.
On the other hand, interest expense represents how much a borrower incurs in interest charges to borrow money.
For example, if a company borrows $1,000,000 to purchase a manufacturing plant and is required to pay 10% interest per year, it will then have to account for $100,000 in interest expense on its income statement.
Interest expense is the cost to companies for borrowing money from banks, financial institutions, investors, or other sources.
Interest Income vs Dividend Income
What is the difference between interest income and dividend income?
As mentioned before, you are entitled to receive interest when you let someone use your money for a fee.
Dividend income is another type of income where a person or entity receives dividends paid by a corporation.
When you buy shares of stock of a publicly-traded company, you may receive dividends paid out to you if the stock is a dividend-paying stock.
A company does not have to pay dividends to its common stockholders but when generates enough business profits to fund its business operations, it can choose to pay out profits to its stockholders.
Interest Income Definition
According to the Corporate Finance Institute, interest income is defined as follows:
Interest income is the amount paid to an entity for lending its money or letting another entity use its funds.
This is a good and simple definition of what interest income means.
You will earn “interest” as a source of “income” when you let someone use your money for a certain period of time.
Interest Income on Income Statement
For companies, where do you find their interest income?
Since interest income is a taxable type of income, companies are required to report the amount of interest revenue they generate in a given period of time.
As a result, you will find a company’s interest earnings on its income statement as it is income that must be reported.
On the income statement, companies must report income from their operations and any other sources of income.
Interest income will typically appear as “other income” or “income from investments” for most companies as their primary operation does not involve the lending of money or generating interest income.
However, if a company’s primary source of income (or a large portion of its income) comes from interest fees, then its income will be reported under income from operations.
Income From Operations
A company that reports its taxable interest income under “income from operations” on the income statement means that it earns interest income as a primary source of income.
For instance, banks and financial institutions lending out money and earning significant amounts of interest income will report their interest income in the income statement as “income from operations” or “operating income”.
A company reporting interest revenues as “non-operating income” or “other income” is one that has taxable interest income to report but its business does not primarily depend on generating interest revenues.
For example, a restaurant or toy manufacturer is not in the business of earning interest income and lending money to companies, businesses, individuals, and consumers.
As a result, any interest income earning on its financial assets will be reported as “other income”.
Interest Income Formula
A very simple interest income formula can be depicted as follows:
Interest = (Principal X Interest Rate) X Term
This is a very simple way to calculate interest income.
In finance and accounting, calculating interest can get quite complicated.
For the purpose of this article, I think this simple formula is useful in explaining how interest is fundamentally calculated.
How To Calculate Interest Income
How do you compute interest income?
- Identify the annual rate of interest on a savings account or investment
- Dividend the annual rate of interest by 100 to convert it into a decimal number
- Multiply the decimal number by the number of years you want to calculate interest
- Multiply that result by the principal value in your savings account
Here is how you calculate simple interest using hypothetical figures.
Imagine you put $10,000 in a savings account giving you an annual interest of 5% and you want to see how much your investment will be worth in 5 years.
- Annual interes rate is 5%
- 5% / 100 = 0.05
- 0.05 X 5 years = 0.25
- 0.25 X $10,000 = $2,500
This means that you will earn $2,500 in interest income over a period of 5 years.
Interest Income Example
Let’s look at a few examples to better illustrate the notion of generating income from interest charges.
For individuals like you and I, we can deposit our money in a savings account with a bank.
By “lending” our money to the bank, the bank will then have to pay us interest based on a pre-determined rate of interest on the capital we’ve deposited.
If you deposited $10,000 in a savings account bearing interest at a rate of 5% per year, you will be entitled to receive $500 every year.
When the bank receives your money, it will use that money to lend out funds to its clients to generate interest income.
This means that you will earn interest on your savings account and the bank will use your money to earn interest by issuing mortgages, personal loans, or lend money to borrowers in other ways.
Another example of how interest income can be earned is when an investor purchase bonds in the bonds market.
A bond is a debt instrument where the investor is effectively the lender of money and the issuer of the bond is the borrower.
In essence, an investor buys a bond (or lends money to a company or entity) and expects to generate a certain amount of interest income on the principal value of the bond (face value).
Interest Income Meaning Takeaways
Is interest income an asset?
What is interest income in accounting?
How to find interest income?
Let’s look at a summary of our findings.
Define Interest Income
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