Definition: Interest is a fee for borrowing an asset from a lender. It can be consider an expense to the borrower and income to the lender. In essence, interest is compensation for a service.
What Does Interest Mean?
The lender allows a borrower to use its money for a period of time in exchange for an interest payment. You can think of interest like a rent payment, but instead of renting equipment or a building you are renting money. It’s a payment for using someone else’s cash for a period of time.
Just about every note, bond, and loan from a bank charges some amount of interest. In fact, some loans are interest only. This means the payments do not go toward the principle at all. Each payment simply pays the regular interest. If additional principle payments aren’t made, the interest payments will continue forever.
Interest is recorded as an expense to the borrower and income to the lender. Take Barb’s Fishing Shop for example. Barb wants to purchase a new delivery truck, but she doesn’t have enough cash to pay for it, so she gets an auto loan. Barb gets a $10,000 10 percent interest loan.
Initially, Barb records the loan by debiting cash and crediting notes payable. When the first monthly payment is due, Barb would debit notes payable for the principle amount paid, debit interest expense for the 10 percent interest charged for the period, and credit cash for the total payment amount.
The bank, on the other hand, would record Barb’s payment by debiting cash for the total payment amount, debiting notes receivable for the principle repayment, and crediting interest income for the amount of interest collected during the period.
Since interest is not typically considered an operating activity, Barb would report the interest expense on her income statement under other expenses instead of putting it under the operating expense section.