While each type of investment has its own risks and mechanism for making money, most investments share some of the same basic characteristics. One of the ways that an investment can gain value is by earning interest. Measuring an investment's worth often relies on an assessment of fair market value. These two economic concepts are tied together in certain cases and can impact how borrowers and lenders behave.
Accrued interest refers to the interest that builds up on a loan, increasing its value until the interest is paid or the loan reaches maturity. Once the borrower makes an interest payment to the borrower, it reduces the accrued interest, which starts accruing again on the predetermined interest schedule.
Fair market value refers to the value of any financial security on an open and free market. It can apply to a loan or any other asset, but only when the buyer and seller make an at-will exchange without undue pressure. Cases such as monopolies do not reflect fair market value. Neither do situations when a seller is under special pressure to make a sale, such as when a seller needs cash quickly to pay off a debt.
Some financial instruments accrue interest, which increases their fair market value. This is generally true whenever the asset doesn't provide regular interest payments to the lender. Even if the lender does receive periodic interest, the fair market value of the asset may rise, then fall with the payment, then begin to rise again. Fair market value takes accrued interest into account, along with the value of the principal (the initial investment) and the ability and likelihood of the asset to earn interest in the future.
One common type of investment that sees its market value rise as it accrues interest is a bond. In particular, some government savings bonds only pay interest when the owner cashes them in. Meanwhile, bonds gain value, since anyone who buys them will be able to take advantage of the accrued interest, plus future interest. Student loans are another type of financial instrument that gain value as they accrue interest. A student who receives a deferral doesn't make payments, but interest still increases the value of the loan. If the lender sells that loan to another company, the presence of accrued interest will increase its fair market value.
The fair market value of assets with accrued interest plays multiple roles in business and personal finance. Businesses must account for accrued interest that increases the value of the assets they hold. This alters a company's balance sheet and increases its stockholders' equity. Selling an asset with accrued interest for fair market value also has tax implications for business and individual investors. Selling the asset for more than it cost will create a capital gain, which is taxable income. This means that knowing the fair market value of assets as they accrue interest is essential to choosing when to sell assets and cash in investments.