Unearned Discount: Meaning, Calculation, Example

What is an unearned discount?

An unearned discount (more commonly called unearned interest) is interest or a financing fee that a lender collects up front but has not yet recognized as income. When collected in advance, the amount is recorded as a liability on the lender’s balance sheet and is gradually recognized as income over the life of the loan. If the borrower repays the loan early, the unearned portion must typically be returned.

Key takeaways

• Unearned discount = interest or fees collected but not yet earned by the lender.
• It is recorded as a liability and converted into income pro rata as the loan matures.
• Common on loans with prepaid or precomputed finance charges; early payoff reduces the lender’s earned portion.

How it works

When borrowers make payments that include interest covering a future period (for example, a monthly payment collected on the 1st that covers the whole month), the portion that applies to future periods is unearned at the collection date. As time passes, a proportional share of that prepaid interest is moved from liability to income, reflecting the lender’s earned interest.

Example scenario:
* A borrower makes a monthly payment of $1,500 on the 1st of each month, $500 of which is interest. On the 1st, that $500 is prepaid and initially unearned. Over the month, a pro rata portion of the $500 is recognized as interest income.

Calculation: Rule of 78 (precomputed loans)

For loans with precomputed finance charges, the Rule of 78 can be used to estimate the unearned discount when a loan is paid off early or refinanced. The unearned discount is computed as:

Unearned discount = F × [k (k + 1) / n (n + 1)]

where:
* F = total finance charge = n × M − P
M = regular monthly payment
P = original loan principal
n = original number of payments
k = number of remaining payments after the current payment

The Rule of 78 front-loads interest (more interest is considered “earned” early in the loan), so it typically favors lenders compared with a simple pro rata refund.

Example

A lender charges a 6% precomputed finance charge on a $10,000 loan to be repaid monthly over 5 years (60 months). The finance charge paid up front is $600.

• The lender records the $600 as an unearned discount (liability).
• With 60 equal payments, each payment causes 1/60th of the $600 (i.e., $10) to be reclassified from liability to income.
• If the borrower pays the loan off early, the remaining unrecognized portion of the $600 must be returned according to the applicable refund method (pro rata or Rule of 78, if specified).

Practical notes

• “Unearned discount” is an accounting concept reflecting timing of income recognition.
• Methods for refunding unearned interest on early payoff vary by contract and jurisdiction; borrowers should review loan terms.
• The Rule of 78 is common in older or precomputed loans but may be restricted by law in some regions due to its front-loaded nature.

Conclusion

Unearned discount (unearned interest) represents prepaid interest recorded as a liability until it is earned over time. Understanding how it’s calculated and recognized—especially with precomputed loans and early repayment—helps borrowers and lenders evaluate the true cost and timing of loan interest.