What is the effective interest method?
It is the method IFRS 9 uses to measure financial assets and liabilities at amortised cost and to allocate interest income or expense over the relevant period. Each period, interest is the carrying amount at the start of the period multiplied by the effective interest rate. The difference between that interest and the cash paid adjusts the carrying amount, so by maturity it equals the amount repaid.
How is the effective interest rate calculated?
The effective interest rate is the rate that exactly discounts the estimated future cash payments or receipts over the expected life of the instrument to its gross carrying amount (for an asset) or amortised cost (for a liability) at initial recognition. In practice it is an internal rate of return: list the cash flows, including the net amount received or paid at the start, and solve for the rate, as Excel's IRR function does.
Which fees and transaction costs are included?
| Included in the effective interest rate | Not included |
|---|---|
| Arrangement or origination fees, and commitment fees for a loan that is drawn | Fees for a service provided separately, such as loan servicing |
| Transaction costs: legal fees, commissions and other incremental costs of issuing or acquiring the instrument | Internal administration costs and overheads |
| Premiums and discounts on issue | Expected credit losses, except for assets that are credit-impaired when bought or originated |
An effective interest rate calculation example
A company borrows CU 1,000,000 for five years at a 5% coupon, paid annually, and pays the bank an arrangement fee of CU 30,000. It receives CU 970,000 but must pay CU 50,000 a year and repay CU 1,000,000 at the end. The rate that equates those cash flows to CU 970,000 is 5.7065%.
| Year | Opening amortised cost | Interest at 5.71% | Cash coupon | Fee spread | Closing amortised cost |
|---|---|---|---|---|---|
| 1 | 970,000 | 55,353 | 50,000 | 5,353 | 975,353 |
| 2 | 975,353 | 55,659 | 50,000 | 5,659 | 981,012 |
| 3 | 981,012 | 55,982 | 50,000 | 5,982 | 986,993 |
| 4 | 986,993 | 56,323 | 50,000 | 6,323 | 993,316 |
| 5 | 993,316 | 56,684 | 50,000 | 6,684 | 0 |
The closing amount in year 5 is shown after the CU 1,000,000 repayment. Over five years the interest expense totals CU 280,000: the CU 250,000 of coupons plus the CU 30,000 fee, spread at a constant rate rather than expensed on day one.
What are the journal entries?
| When | Entry | CU |
|---|---|---|
| Day one | Dr Cash, Cr Loan liability | 970,000 |
| End of year 1 | Dr Interest expense 55,353; Cr Cash 50,000; Cr Loan liability 5,353 | 55,353 |
A lender holding the same loan at amortised cost mirrors these entries, recognising interest income at the effective rate, with a loss allowance for expected credit losses on top. See classification and measurement.
Can you calculate it in Excel?
Yes. The Effective interest calculator (Excel) works out the effective interest rate from the cash flows, builds the amortised cost schedule for up to 20 years and tests modifications of the terms. It opens with this loan already entered.
What happens when estimates change?
If a company revises its estimate of the cash flows, other than for credit losses, it recalculates the carrying amount as the present value of the revised cash flows at the original effective interest rate and recognises the adjustment in profit or loss. For floating-rate instruments, changes in the market rate simply change the interest; the effective rate is updated periodically. For renegotiated terms, see modifications of financial instruments; for interest rate swaps on loans, see hedge accounting.
Need help applying the standards?
Our Chartered Accountants help finance teams and students apply IFRS and US GAAP to real transactions.
Questions people ask
What is the effective interest rate?
The rate that exactly discounts a financial instrument's expected future cash flows to its initial carrying amount, including fees and transaction costs that are part of the yield.
How do you calculate amortised cost?
Start with the initial carrying amount, add interest at the effective interest rate, deduct cash payments, and deduct any loss allowance for an asset.
Are transaction costs included in the effective interest rate?
Yes, for instruments not measured at fair value through profit or loss: incremental costs such as legal fees and commissions are included.
Is the effective interest rate the same as the coupon rate?
Only if there are no fees, costs, premiums or discounts. Otherwise they differ.
Sources
Every fee, date and rule on this page was taken from these official and primary sources.
Rules and fees change. If you are reading this long after October 4, 2026, confirm the figures with the source before you rely on them.
Related guides
More in IFRS 9
This guide is general information. It is not tax or legal advice for your situation.