Unearned interest is a term that is used to identify the amount of interest that is collected on a loan before the borrower has had sufficient time to benefit from the principal of the loan. Just about every type of loan structure today commonly involves the payment of unearned interest during the early months of the loan repayment period. As the borrower begins to reap benefits from the assets acquired with the loan, the advanced interest increasingly is viewed as earned by the lender.
When it comes to such standard consumer loans as mortgages and auto loans, the terms and conditions of the loan contract will include details about the amount of interest collected in advance. This will often follow a pattern of each monthly payment going toward the interest that is anticipated to apply to the loan over the series of payments specified. Depending on the terms, a larger percentage of each monthly payment will go toward unearned interest during the first half of the loan period. As the balance due decreases, the interest accounts for a smaller percentage of the monthly payment.
Some schools of finance view all interest that is paid during the course of the loan to be unearned until the loan is settled in full. According to this approach, the borrower does not receive the full benefit of the loan until the acquired property is no longer encumbered by the mortgage or terms of the loan agreement. Once the loan is paid in full, the borrower is understood to have earned the interest that was paid.
With some loans, there are provisions for the borrower to pay off the loan early and thus enjoy a reduction in the rate of interest applied. Depending on the specific structure of the loan, it may be possible for the borrower to pay off the loan early and actually be due a refund of a portion of the unearned interest that has already been paid. However, this is a relatively rare situation. More commonly, lending institutions tend to structure the accrual of unearned interest in a way that will not require refunding interest to the borrower.