Interest Income

What is Interest Income?

Interest Income is the revenue earned by lending money to other entities. The term is usually found in the company's income statement to report the interest earned on the cash held in the savings account, certificates of deposits, or other investments. Typically, the net interest income is taxable and is presented in the income statement of the individual or organization.

Interest Income - What Is It, Formula, Examples, Taxation, Types (1)

You are free to use this image on your website, templates etc, Please provide us with an attribution link

Since this interest is not a part of the original investment, it is separately recorded. It is obtained by multiplying the principal amount by the interest rate for the period the money was lent. Investors who invest in banking stocks can determine the financial health of those stocks by analyzing net interest income.

What is Interest Income?
- Interest Income Explained
- Formula
- Types
- Examples
- Interest Income Explained in Video
- Accounting
- Taxation
- How does It Work? (Individuals vs. Banks)
- Interest Income Vs Dividend Income
- Recommended Articles

Interest Income Explained

Interest income is a critical financial concept that plays a pivotal role in personal finance and investment strategies. It refers to the earnings an individual or entity receives from lending out their money or investing in interest-bearing financial instruments, such as savings accounts, certificates of deposit (CDs), bonds, or other fixed-income securities. This income is typically calculated as a percentage of the principal amount, known as the interest rate, which is paid regularly over a specified period.

One of the most common sources of interest income is a savings account. When an individual deposits money into a savings account, the bank pays them interest as compensation for keeping their funds with them. The interest rate, often expressed annually, determines how much income the account holder will earn. Similarly, when someone invests in bonds or CDs, they receive periodic interest payments until the maturity date when they receive their initial investment back.

Formula

To calculate net interest income, you can use a straightforward formula that takes into account the principal amount, interest rate, and time period involved.

Interest Income = Principal Amount × Interest Rate × Time Period

Types

There are two types – Income from Operations and Other Income. Let us understand both of them in detail through the discussion below.

#1 - Income from Operations

Interest Income - What Is It, Formula, Examples, Taxation, Types (3)

source: Bank of America SEC Filings

In cases where the company's income statement shows Income from Operations and Other Income separately, the types of Interest. Income depend upon the primary operations of the business. If the business is primarily making income from the interests like lending companies and financial institutions, this is taken as Income from Operations. As the example above notes, Bank of America's core income is from "Interest."

#2 - Non-Operating Income (Other Income)

Interest Income - What Is It, Formula, Examples, Taxation, Types (4)

source: Starbucks SEC Filings

If the core income does not come from interest, it is non-operating interest income and comes under other income.

All individuals, as well as organizations, have financial assets from which they earn a variety of interests. The interest earned on these investments is taken as an income for the organization.

In most cases, the interest earned by the individual or the organization is reported in the income statement under Income from Operations or Other Income. The Internal Revenue System (IRS) has mandated that this interest be reported as taxable income.

Examples

Now that understand the basics, formula, and types of an interest income calculator, let us apply the theoretical knowledge to practical application through the examples below.

Example #1

Let us take an example of Bank of America. Revenue for a bank is different from the revenue of a non-financial company. Revenue for a bank comprises net interest income and net non-interest income.

For Bank of America, the total interest earned for the period was $57.5 billion.
And the net interest income (total interest minus total interest expense) was $ 44.6 billion.

Example #2

Axis Bank, one of India’s largest private-sector banks declared their financial report for the first quarter of FY24. In their report, it was stated that their net profit was at Rs. 5,797 crores which is 41 percent higher in terms of YoY figures.

The net interest income of the banking giant grew 27 percent year-on-year to Rs. 11,959 crores. A top executive of the bank said that their corporate financing parallel has been growing and the coming quarters are set to experience further growth as well.

Interest Income Explained in Video

Accounting

Now that we understand the intricate details of net interest income, it would be incomplete if we do not discuss how to account for it. Let us do so through the discussion below.

Regarding the accrual method of accounting, the interest is recorded as earned and not necessarily as paid by assuming that the risk of receiving payment is low. The calculation of this accrued interest is dependent on the interest rate, the compounding period, and the investment balance. A detailed understanding of investment terms and conditions is required to keep a proper accounting record for interest.
It is obtained from the entity's investments that pay interests, such as a savings account or certificate of deposit. It can be either paid in cash or may have been accrued as earned but not yet paid. In the latter circ*mstances, this can only be reported if there is a probability of receiving cash, and the amount of payment to be received can be ascertained.
It should not be confused or mixed up with dividends, as both are different. The dividend is paid to the holders of a company’s common or preferred stock, which signifies the distribution of the issuing company's retained earnings.
The penalties paid by the customers on overdue accounts receivable are also treated as income because these payments are related to the use of the company’s funds like accounts receivable by the customer. Some companies prefer to mention this type of income as penalty income. It is reported within the interest income account in the general ledger. It is a line item and is generally recorded separately from interest expense in the income statement. This income is taxable as per IRS, and the ordinary tax rate is applicable.
The types of assets that help in earning interest for the bank are mortgages: auto loans, personal loans, and commercial real estate loans.

Taxation

Most individuals look to grow their net interest income to amass significant wealth for retirement. However, it is critical to be smart about the taxation aspect of it to ensure the taxes do not eat away a large chunk of the gains. The points below are a detailed explanation of different aspects of taxation.

Interest income earned from sources like savings accounts, bonds, or CDs is subject to federal income taxes in the United States.
Interest income is typically taxed at an individual's ordinary income tax rate, which can range from 10% to 37%, depending on their total income.
Interest income from certain government bonds, such as U.S. Treasury bonds, is exempt from state and local income taxes but is still subject to federal taxes.
Tax-advantaged accounts like Individual Retirement Accounts (IRAs) and 401(k)s allow individuals to defer taxes on interest income until they withdraw the funds, potentially offering tax benefits for long-term savings.

How does It Work? (Individuals vs. Banks)

Suppose a person runs a big sized capital goods business and has a balance of $10 50,000 in the company's savings account. Now it must be understood that this $10 50,000 will not lie idle in the account until the owner decides to withdraw the entire amount.
The bank in which the savings account is maintained loans this money to the other people and, in return, gets interested in this loan amount. The bank, in this situation, keeps a small percentage of the amount of $10 50 000 deposits in its hand. This system is also known as fractional banking.
Now, these loans given by the bank can be long-term or short-term. Short-term loans are the overnight loans that are given to other banks. Since the bank is getting money on the person’s deposit, the bank then pays an amount as interest to the owner of the deposit so that the owner is motivated to keep the money in the account. So, for the entire year, the cash balance is the earning interest paid by the bank at the end of each month.
The bank must send out the details of how much interest it has paid the owner of the deposit in the bank account. Based on this statement, the deposit owner gets a clear idea of how much taxable interest income he has earned on the financial assets. So the owner’s business gets the interest payment, which is recorded in his income statement as income.

Interest Income Vs Dividend Income

Both these types of income are generated from different sources and are accounted and taxed differently as well. Let us understand the differences through the comparison below.

Interest income is earned primarily from fixed-income investments like bonds, savings accounts, and certificates of deposit (CDs).
It is paid to investors as regular interest payments, usually on a predetermined schedule, such as monthly or annually.
Generally, interest income is considered lower risk compared to dividend income because it is often guaranteed, especially in the case of government bonds.
Interest income is typically taxed as ordinary income, subject to an individual's income tax rate.

Dividend Income

Dividend income is generated from owning shares of stocks in publicly traded companies.
It is distributed to shareholders periodically, typically on a quarterly basis, and is based on the company's profitability.
Dividend income is generally associated with higher risk because it can vary based on a company's financial performance and dividend policy.
Qualified dividend income may receive preferential tax treatment with lower tax rates, but non-qualified dividends are typically taxed as ordinary income.

Interest Income - What Is It, Formula, Examples, Taxation, Types (2024)