There are three common ways the interest rate is calculated by lenders. Each calculation or loan accrual method can result in significant payment variations, so understanding the three options can help investors understand the details of their loan documents and increase their awareness when making a loan decision.
Actual/360
This interest rate formula, which is also referred to as 365/360, is the most common method used by banks. It’s also the most controversial; this method has been challenged in court due to its deceptive nature. This method is calculated by dividing the annual interest rate by 360, then multiplying it by the number of days in the month. This results in the most expensive accrual method since it has the highest daily and monthly accrual rate.
30/360
The 30/360 interest rate formula similarly assumes that each year has 360 days, but it also assumes every month has 30 days, thus simplifying the calculation. This method is most in favor of the borrower and is the easiest to calculate. The calculation is determined by dividing the loan’s annual interest rate by 360. This gives you a daily interest rate, which is then multiplied by 30 to get the monthly interest rate. The monthly accrual rate can then be multiplied by the outstanding balance to determine the overall interest accrual amount. This method is most commonly used by insurance companies.
Actual/365
This method is the most logical method to calculate interest, and is calculated by dividing the annual interest rate by 365, which is the total number of days in a typical year. That calculation is then multiplied by the number of days in the current month. In this method, the daily interest rate is slightly lower, but the annual interest rate is slightly higher since months have varying numbers of days. This method is used by Fannie Mae.
Let’s look at a comparison of the three accrual methods, assuming that the loan amount is for $1,000,000 and the interest rate is 4%.
Formula | Loan Amount | Interest Rate | Actual Interest Rate | Total Paid Interest |
|---|---|---|---|---|
Actual/360 | $1,000,000 | 4% | 4.058% | $218,341 |
30/360 | $1,000,000 | 4% | 4.000% | $214,942 |
Actual/365 | $1,000,000 | 4% | 4.003% | $215,116 |
As you can see in the above example, what may seem like a minor difference can cost the borrower an additional amount in the thousands per year, or even hundreds of thousands if you calculate a larger loan. It’s clear that the 30/360 formula will result in the lowest interest paid, and the Actual/360 will result in the highest.
This is one of the many details to consider when choosing your lender. All loans and all lenders are not created equal. We hope this allows you to better understand the details of the loan documents you will be signing. This is part of our series focusing on the terms of your loan and our focus that making a loan decision is more than just a rate.
I have a wide range of options to help you find the best loan terms and rate. Get in touch with me today if you’re interested in learning more about the services I provide through Gantry.