Accrual Rate: the rate at which interest is gained on a financial obligation, investment, or other things of interest, such as a worker’s leave days, vacation days, etc.
Accrual Rate Details
For financial loans, the accrual rate is the percentage interest rate that applies to the remaining principal. Usually, for loans, you make periodic payments to offset interest and part of the principal. The accrual rate is used to determine the percentage interest applicable to the remaining principal at the end of an installment period.
Accrual rate is also used with bonds. Bonds are a form of debt security that a government or corporation uses to raise money. The issuer of the bond is the borrower, while the holder of the bond is the lender. The issuer of the bond promises to pay a predetermined periodic interest to the bondholder. The issuer also pays the principal at a later date called the maturity date of the bond. Since the issuer pays interest on bonds periodically, the issuer will have to calculate the accrual rate at the end of each payment period. For example, if a bond issuer is supposed to pay an annual interest of 8%, with interest paid twice a year ( i.e., after six months), then the issuer will pay 4% at the end of the first six months and another 4% at the end of the next six months. In this case, the accrual rate will be 4%.
Accrual rate also refers to the rate at which employees earn vacation or leave time. For example, a company policy might state that employees make five hours of vacation or leave for every 100 hours at work. So the accrual rate is 5 hours per 100 hours.
Example of Accrual Rate
Mr. Aza is a farmer and has been looking for a loan to expand his farming to include rice storage. He was able to secure a loan with Blue Bank. Blue Bank offered him a loan of $500,000 at an annual interest rate of 9%. Mr. Aza planned to buy rice during harvest when the rice is cheaper. He will then treat the rice, store it, and sell it later in the year when the price is higher. With this plan in mind, Mr. Aza negotiated with Blue Bank to only pay the interest on the loan and later pay the principal as a lump sum at the end of the year. He will pay the principal when he sells the rice he has stored at the end of the year. Mr. Aza will pay his interest in installments, spread across 12 months. What is the accrual rate for Mr. Aza’s loan, and how much will he pay monthly?
The accrual rate is the percentage of principal that Mr. Aza will pay at the end of his installment period which is one month. Since Mr. Aza will not be paying any part of the principal until the end of the year, the principal will remain constant throughout the year. To find the accrual rate for a loan with a constant principal, divide the annual interest rate by the number of installment periods. The solution is as follows:
- The annual interest rate is 9%.
- The number of installment periods is 12 months.
- Accrual rate = 9% / 12 = 0.75%
- Mr. Aza's accrual rate is 0.75%, meaning that Mr. Aza will pay 0.75% of the principal at the end of each installment period, which is one month.
- To calculate the amount of money that Mr. Aza will pay monthly, multiply the principal's accrual rate.
- Accrual rate = 0.75% = 0.0075
- Loan Principal = $500,000
- Mr Aza’s monthly instalment = 0.0075 * 500,000
- The final answer is $3,750.
Significance of Accrual Rate
Understanding the accrual rate will help you make smarter financial decisions. For example, a bank offers you a loan at a flat rate of 2% per month, and another bank offers you another loan at a flat rate of 20% per annum. Which loan should you accept? In both cases, you will repay the loan through installments. Using the knowledge of accrual rate, you will calculate the accrual rate of the second loan.
If you calculate the accrual, you will get 1.67%, which is lower than the first loan's accrual at 2%. So from the accrual rate, it’s wiser to choose the loan from the second bank, which is 20% per annum.