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An implicit interest rate is the nominal interest rate implied by borrowing a fixed amount of money and returning a different amount of money in the future. For example, if you borrow $100,000 from your brother and promise to pay him back all the money plus an extra $25,000 in 5 years, you are paying an implicit interest rate. There are other situations in every day life where you will encounter implicit interest rates.
What is the implicit interest rate under IFRS 16?
The rate implicit in the lease is the interest rate charged by the lessor in the lease agreement. This is essentially the return or margin the lessor is receiving from the lease agreement, and as such, the lessor can be unwilling to name the rate outright. Since the rate of return for the lease is not stated, it is implied.
Under IFRS 16, the lessee will use the implicit rate to calculate the initial measurement of the lease liability, assuming the rate can be readily determined. More often than not, as a lessee, this rate is not readily determinable as it is driven by lessor inputs such as costs and profit assumptions. If the rate is not readily determinable to the lessee, the lessee should use their own incremental borrowing rate in place of the implicit rate. The implicit rate is always known to the lessor since the lessor is the one drafting the terms of the lease, and therefore is aware of what interest rate they have incorporated within the lease agreement.
Calculating Implicit Interest Manually
Define implicit interest. If you borrow money from someone and agree to pay it back with an additional amount, you are not specifying any interest or interest rate. Let’s use the example that you borrow $100,000 from your brother and promise to pay him back in 5 years plus an extra $25,000. In order to find the interest rate that is “implicit” or “implied” in this agreement, you need to do a mathematical calculation.
- The formula you will use is total amount paid/amount borrowed raised to 1/number of periods = x. Then x-1 x100 = implicit interest rate.
Calculating Implicit Interest Using a Spreadsheet
Click on cell A1 and then on the formula bar located above the column names. If you are taking out a $300,000 real estate mortgage with monthly payments of $2,000 for 30 years, enter this function formula in the formula bar: =RATE(30*12,-2000,300000). Then hit return.
The function calculates the value at .59%, which is a monthly interest rate. To annualize this monthly rate, multiply it by 12, and you get an implicit annual interest rate of 7.0203%.
Determine implicit interest for bond purchases
When purchasing bonds, an implicit interest rate is the difference between the current yield (dividend) paid on a bond and the rate that the bondholder will receive at a fixed point in the future. The implicit rate may change from the rate stated in the bond contract at the time of purchase, since bonds can rise or fall in value during the bond term.
- For example, you purchase bonds with a promised dividend of $5.00 per share to be paid in one year. Due to fluctuations in the marketplace, you receive $10.00 per share on the one-year due date. The implicit interest rate earned is 50%.
Using Implied Interest
Calculate implicit interest before borrowing or leasing. If there is not an explicit interest stated, you should always calculate the implied interest rate before signing a lease or taking out a loan. This rate will determine your total financing expense. Do not rely only on monthly payment amounts or short-term yields on bonds before making financing decisions.