By Adam Parker
This is a straightforward question, and most commercial/multifamily borrowers would likely answer by rattling off the interest rate attached to a specific piece of real estate. And their answer would be correct. However, would borrowers know the answer to a follow-up question of…what interest calculation method does your lender use? I suspect some borrowers would know the answer, but I’m guessing that question might stump quite a few. In turn, I’ll detail the three most common interest calculation methods below in hopes of shedding some light on a topic that often isn’t discussed.
There are three methods of interest calculations:
The first method, the preferred method, is called 30/360, and it requires borrowers to pay interest for 360 days in a year by applying the simplified assumption of twelve months of 30-days each. Life Insurance Company lenders are the lenders that primarily use this interest calculation.
The second method is called Actual/360, and its calculation requires borrowers to pay interest based on the number of days between pay periods which results in greater interest to the lender while allocating less of the payment towards principal reduction. The actual payment remains the same, however. CMBS lenders and the Agencies use this calculation, as do many banks, credit unions and debt funds. Specifically, This method divides the interest rate by 360 to get the daily interest rate and then it’s multiplied by actual days in a month. This method was challenged in court citing Actual/360 is misleading to borrowers, but the method was proven legal since the lenders properly disclosed their interest calculation.
And the third method is called Actual/365, and it requires borrowers to pay interest for 365 days in a year (or 366 days in a leap year). This method can be used for commercial real estate loans but is typically used for non-real estate related consumer loans such as car loans.
Example
If I were to compare a $5,000,000 loan at a 6% rate using a 5-year loan term and a 30-year amortization, the difference in effective rate between a 30/360 calculation and Actual/360 calculation is 9bp. As a reminder, your mortgage payment does not change with any of these interest methods, it’s just how much interest you pay versus how much principal you pay. For our above example, the payoff amount for the 30/360 method is $4,652,718, and the payoff amount for the Actual/360 method is $4,677,253. That’s a difference of $24,535 in a 5-year period.
In an environment where every basis point counts, it would be wise for borrowers to consider a lenders’ interest calculation method.