For loans such as a home mortgage, the effective interest rate is also known as the annual percentage rate (APR). The rate takes into account the effect of compounding interest along with all the other costs that the borrower assumes for the loan. Under the effective interest method, the semiannual interest expense is $6,508 in the first period and increases thereafter as the carrying value of the bond increases.

Tax Implications of Amortizable Bond Premiums

As the table shows, the interest for each period is $6,702 and the total over the 10 periods is $67,024 under the straight-line method. Alternatively, the bond’s carrying value on 1 July 2020 is premium amortization formula equal to the unamortized discount of $6,516. Finally, the unamortized discount of $6,516 on 1 July 2020 in Column 5 is equal to the original discount of $7,024, less the amortized discount of $508. The bond’s carrying value in Column 6 is thus increased by $508, from $92,976 to $93,484. Let’s now consider how to use the effective interest method for both the discount and premium cases. For example, under this method, each period’s dollar interest expense is the same.

How to Calculate Constant Yield

In capital finance and economics, the effective interest rate for an instrument might refer to the yield based on the purchase price. The effective interest method of amortization is a process used to allocate the discount or premium on bonds, or other long-term debt, evenly over the life of the instrument. 1) A latex\$10,000/latex bond has a coupon rate of latex6.5\%/latex. The bond was purchased when there was three years to maturity and the yield rate was latex5\%/latex. When a bond is sold at a premium, the amount of the bond premium must be amortized to interest expense over the life of the bond. When we issue a bond at a premium, we are selling the bond for more than it is worth.

Bond Premium with Straight-Line Amortization

However, as the carrying value of the bond increases or decreases, the actual percentage interest rate correspondingly decreases or increases. Remember, the calculator will not tell you the entries for the last column (remaining discount to be accumulated), so you will need to complete this column manually. Founded in 1993, The Motley Fool is a financial services company dedicated to making the world smarter, happier, and richer. The Motley Fool reaches millions of people every month through our premium investing solutions, free guidance and market analysis on Fool.com, top-rated podcasts, and non-profit The Motley Fool Foundation. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.

• Investors must report bond interest income and bond premium amortization on their annual tax returns.
• DebtBook also offers another acceptable form of the Effective Interest method that takes into account the callability of maturities.
• This premium often arises because the bond’s coupon rate (interest rate) is higher than the current market rate, making it more attractive to investors.
• The entries for 2023, including the entry to record the bond issuance, are shown next.
• This 50,000 up here that is always what goes into the bonds payable, and then we have to balance this out with the 4,000 going to the premium on bonds payable.
• The straight line method amortization for each period, and produces an effective interest method amortization schedule showing the premium or discount to be amortized each period.

Straight-Line Method

Well, like we learned before, we would do the 50,000 times 108%, which is 1.08. So since the cash is 54,000, but later on when we pay off these bonds, we are only going to pay off 50,000. So our journal entry as we learned, we had a debit to cash for the 54,000 we just calculated. And as we discussed, this is always going to be the principal amount of the bonds.

• So we’re going to debit cash here because we received cash of 47,000 and we’re going to credit bonds payable.
• Investors pay less than the bond’s face value because its interest payments are less attractive.
• The following T-account shows how the balance in the account Premium on Bonds Payable will decrease over the 5-year life of the bonds under the straight-line method of amortization.
• In this way, the effective rate accounts for the purchase price and compounding.
• The effective interest method of amortization causes the bond’s book value to increase from $95,000 on Jan. 1, 2017, to $100,000 prior to the bond’s maturity.

If the investor holds onto the bond until maturity, the investor receives the redemption price of latex\$1,000/latex. The bond discount of latex\$50/latex represents a capital gain for the investor. One option is for the investor to claim all of the capital gain as taxable income at the time of redemption, which results in a higher taxable amount at the time of redemption. This allows the investor to spread the capital gain over each payment interval, claiming a little bit of the capital gain along with each bond payment. This results in a higher taxable amount for each payment interval, but results in lower taxes overall because the capital gain is not claimed as a single lump-sum taxable expense on the maturity date. The bond amortization calculator calculates the total premium or discount over the term of the bond.

How is the straight-line method of amortization applied in valuing a bond?

• To account for the premium paid on a bond, the investor has the option to amortize or spread out the deduction of the premium over the remaining term of the bond.
• You must calculate the book value of the bond debt (\(BVD\)) after 10 years.
• A bond sold at a premium to par has a market price that is above the face value amount.
• It pays a 5% coupon rate semi-annually and has a yield to maturity of 3.5%.
• This means that when a bond’s book value decreases, the amount of interest expense will decrease.

The constant-yield method will give you a smaller amortization amount than the straight-line method in early years, with the constant-yield amortization figure growing in later years. That puts it at a overall disadvantage cash flow to the straight-line method from the taxpayer’s standpoint, which might be one reason why tax laws were changed to have newer bonds use the less favorable method. For the years in which you own the bond for all 12 months, you simply take amortization of 12 times the monthly amount. For the year of purchase and the year of sale or maturity, you have to account for a partial year, multiplying the monthly amount by the number of months during the year that you actually owned the bond.