30/360 vs Actual/360 vs Actual/365: Loan Accrual Calculations Explained
Believe it or not, there is more than one way to calculate the interest portion of a loan payment. Borrowers should be careful to read their loan documents to know how interest will be applied. Different methods can have a significant difference in how much interest is paid over time.
Many of us are used to simple interest, which is the method used on auto loans and credit cards. The amount of interest charged is calculated as follows:
Balance X Rate / 365 X Number of Days since last payment = Interest portion of payment.
Most commercial loans and mortgages use amortizing payments. The payment is due on the same date every month (usually the first) and interest is calculated for the period between due dates, regardless of when payment is actually made. However, there are still different methods of interest calculation that can change the interest portion of the payment.
30/360 assumes there are 360 days in a year, and each month has the same number of days. This method charges the least amount of interest over time because the daily rate (rate / 360) is applied to a 360 day borrowing period (30 X 12). The method was used before calculators were invented because it is easier to calculate: the rate can simply be divided by 12 to get a monthly rate.
Actual / 360 divides the rate by 360 to get a daily rate and multiplies by the actual number of days in a month. Over the course of a year, the daily rate is applied to 365 borrowing days. Therefore, the borrower pays more interest over the life of the loan than in either of the other methods.
Actual / 365 divides the rate by 365 to find the daily rate, then multiplies by the actual number of days in a month. This method is the most accurate of the methods. The borrower pays slightly more in interest over time under this method than under the Actual / 360 method.
At AAI Financial, we assist our client borrowers by carefully reviewing all lender documentation and helping them understand the various terms and conditions to which they are agreeing.
