Amortization of Bond Premium Guide on Amortization of Bond Premium

how to calculate bond premium amortization

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Understanding the Effective Interest Rate Method

  • The effective interest method of amortization causes the bond’s book value to increase from $95,000 January 1, 2017, to $100,000 prior to the bond’s maturity.
  • Calculating bond premium amortization using the straight-line method couldn’t be simpler.
  • Ask a question about your financial situation providing as much detail as possible.
  • The bond amortization schedule calculator is one type of tvm calculator used in time value of money calculations, discover another at the links below.
  • For the years in which you own the bond for all 12 months, you simply take amortization of 12 times the monthly amount.
  • The amortization can be done equally in each accounting period up to the end of the bond’s life.

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Amortizing Bond Premium With the Constant Yield Method

It is valued at the present value of interest payments and face value determined based on the market interest rate. The investors pay more than the face value of the bonds when the stated interest rate (also called coupon rate) exceeds the market interest rate. In how to calculate bond premium amortization a case where the bond pays tax-exempt interest, the bond investor must amortize the bond premium. Although this amortized amount is not deductible in determining taxable income, the taxpayer must reduce their basis in the bond by the amortization for the year.

How to Amortize Bond Premium?

how to calculate bond premium amortization

Reducing the bond premium in a logical and systematic manner is referred to as amortization. Although some bonds pay no interest and generate income only at maturity, most offer a set annual rate of return, called the coupon rate. The coupon rate is the amount of interest generated by the bond each year, expressed as a percentage of the bond’s par value.

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Usually a bond’s stated interest rate is fixed or locked-in for the life of the bond. If the central bank reduced interest rates to 4%, this bond would automatically become more valuable because of its higher coupon rate. If this bond then sold for $1,200, its effective interest rate would sink to 5%. While this is still higher than newly issued 4% bonds, the increased selling price partially offsets the effects of the higher rate. Below is a comparison of the amount of interest expense reported under the effective interest rate method and the straight-line method. Note that under the effective interest rate method the interest expense for each year is decreasing as the book value of the bond decreases.

  • The reason is that the bond discount of $3,851 is being reduced to $0 as the bond discount is amortized to interest expense.
  • The combination of these two accounts is known as the book value or carrying value of the bonds.
  • In the case of the 9% $100,000 bond issued for $104,100 and maturing in 5 years, the annual straight-line amortization of the bond premium will be $820 ($4,100 divided by 5 years).
  • A fixed-rate residential mortgage is one common example because the monthly payment remains constant over its life of, say, 30 years.
  • This bond amortization calculator can be used for any bond up to a maximum term of 200 interest payment periods.
  • The discount will increase bond interest expense when we record the semiannual interest payment.
  • That puts it at a overall disadvantage 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.
  • While this is still higher than newly issued 4% bonds, the increased selling price partially offsets the effects of the higher rate.
  • If the bond in the above example sells for $800, then the $60 interest payments it generates each year represent a higher percentage of the purchase price than the 6% coupon rate would indicate.
  • In lending, the effective annual interest rate might refer to an interest calculation wherein compounding occurs more than once a year.

If you’re reading this because you want to learn more about stocks and how to invest, check out The Motley Fool’s Broker Center to learn how to get started. Dheeraj Vaidya, CFA, FRM is Co-Founder of Wallstreetmojo.com and https://www.bookstime.com/ possesses 18+ years of expertise in Financial Modeling, Valuations, and Excel. With a background as a former Equity Research Analyst at JPMorgan and CLSA, he brings unparalleled proficiency to these key financial domains.

When is the straight-line method of amortization used in deferring taxes?

how to calculate bond premium amortization

Under the effective interest rate method the amount of interest expense in a given accounting period will correlate with the amount of a bond’s book value at the beginning of the accounting period. This means that as a bond’s book value increases, the amount of interest expense will increase. Companies may also issue amortized bonds and use the effective-interest method.

When is the straight-line method of amortization used in ensuring bondholders?

how to calculate bond premium amortization

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