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Did you know that there is more than one way for interest to accrue on a commercial loan? In practice, there are three main accrual methods that are used. While all loans come with an interest payment, some end up accruing far more interest than others. With that in mind, we've laid out the three main accrual methods for you below, including the 30/360 day count. Keep reading to learn how each of these accrual methods works and which one you should try to secure for your loan.
What is a 30/360 accrual method?
This interest accrual method takes the interest rate that you are given at face value. It assumes that there are 360 days in a year and 30 days in each month. Notably, while this type of Interest calculation returns a higher daily accrual amount because the interest rate is divided by 360 days rather than 365, which is the actual number of days in a year. However, in general, it typically generates the lowest amount of Interest overall because it assumes that every month has 30 days, even when there are 31 days in a month.
The formula for the 30/360 accrual method is as follows:
- Calculate the daily accrual rate: Divide the interest rate by 360 to get the daily accrual rate.
- Find the monthly interest rate: Take the daily interest rate and multiply it by 30 to get the monthly interest rate.
- Figure out the monthly accrued interest: Multiply the monthly accrual rate by the outstanding balance on the loan to get the total amount of monthly accrued interest.
A practical example
For this example, let's assume you received a 4% interest rate on a $1 million loan for an office building. Although it's not totally applicable for this accrual method, let's assume you made your first payment on the loan in January, a month that has 31 days in it.
- Daily accrual rate: 4% / 360 = 0.00011%
- Monthly interest rate: 0.00011% x 30 = 0.00333
- Monthly accrued interest: 0.00333% x $1 million = $3,333
What is an actual 365 accrual method?
In contrast, the actual 365 method is calculated by taking the annual interest rate, dividing it by 365, and then multiplying it by the exact number of days in each month. For example, in the month of February, you would multiply by 28 days rather than 30, unless it's a leap year.
Importantly: While dividing the annual interest rate by 365 results in a slightly lower daily rate, you will likely end up paying more interest over the life of the loan because the daily rate is accruing more times over.
A practical example
Assume the same information for this calculation: a 4% interest rate and a $1 million current loan balance. For the purposes of this example, please assume it is currently January. For the record, January always has 31 days.
You will also follow the same method for calculation that was listed above. However, you will divide the interest rate by 365 instead of 360 and you will multiply the daily interest rate by the number of days in the given month.
- Daily accrual rate: 4% / 365 = 0.000109
- Monthly interest rate: 0.000109% x 31 = 0.003379
- Monthly accrued interest: 0.003379% x $1 million = $3,790
What is an actual 360 accrual method?
Finally, with the actual 360 method, the annual interest rate is divided by 360 and then multiplied by the actual number of days in the month. This method ends up being the most expensive of all three methods because, in this instance, when you divide the annual interest rate by 360 rather than 365, you got a larger daily rate. However, since you're also multiplying by the actual number of days in the month, the day rate also ends up accruing is more times over.
Notably, borrowers have taken banks and lenders to court over this accrual method, saying it's deceptive and predatory. While the banks have ultimately won these suits because they did disclose the method of calculation and each accrual factor in their paperwork, it's crucial to keep an eye out for this practice. If you can at all avoid this type of interest calculation, you should try to do so.
A practical example
Again, this example uses the same figures as the earlier ones. For the purposes of this calculation, assume a 4% interest rate on a $1 million loan. You should also assume that it is currently January, which is a month that has 31 days in it.
- Daily accrual rate: 4% / 365 = 0.000109%
- Monthly interest rate: 0.0109% x 31 = 0.00339%
- Monthly accrued interest: 0.0039 x $1 million = $3,900
Which accrued interest method is right for you?
As you can see by looking at those practical examples above, the amount of interest charges that you pay on your loan can vary greatly, according to the number of accrued days that you have in each accrual period. With that in mind, if paying the least amount of interest overall is your goal, you should look for a loan that has a 30/360 accrual method.
On the other hand, if buying the commercial asset was a stretch for you, you may want to look into a loan that has an actual 365 accrual method. While you may end up paying a little bit more interest in total, your monthly payment will be smaller some months. In February for instance, when there are only 28 days, you will be expected to pay less.
The bottom line
No matter which accrual method you end up choosing for your commercial loan, the most important thing is that you're aware of how your loan accrues interest. Be sure to read the fine print on any documents that you sign and ask your lender if you have any specific questions about your loan and how the accrual method works. Armed with this knowledge, you can make an informed decision about whether or not a particular loan is the right fit for you.
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