While the difference may not seem like much at first, a lender’s use of this legally deceptive practice could cost you thousands of dollars extra over the life of a loan. This method of calculating interest has held up against attacks in courtrooms across the nation and the Wisconsin Legislature even went as far as enacting a statute that explicitly makes it legal. All the lender has to do is disclose it in the note (meaning it does not have to show up in the loan commitment), which the borrower may not see until closing. It is known as either 365/360 or actual/360.
How it works: the lender pretends there are 360 days in a year when calculating the daily interest rate (6% / 360 > 6% / 365), then charges interest on 365 days (366 during a leap year). In using the 365/360 method on a loan with a rate of 6%, the lender will actually be charging an annual rate of 6.083% (.06 / 360 x 365). Other than to deceive, it makes no sense for a lender to use this method. Anything the lender would be trying to achieve using the 365/360 method can be accomplished with the 365/365 method (information on this similar method below). It is not any more difficult for a lender to divide by 365 than it is to divide by 360.
If the financial institution plans to charge a borrower 6.083%, it should say so. The only reason to quote 6.00% and calculate interest on a 365/360 basis is to make the interest rate look more enticing.
I first came across this issue when I was observing a real estate closing a few months ago. The transaction involved the sale of an apartment building with the buyer borrowing about half of the purchase price from a bank. The term of the loan was for five years, and will amortize over 30 years. What this means is that even though the loan will mature after five years, the buyer will be making payments as if the loan is to be paid off over 30 years. So after the five-year term of the loan ends, the buyer will still have a very large remaining balance that needs to be paid to the bank (called a balloon payment). Typically what happens after five years is that the borrower and the lender will negotiate a new loan for another five years.
While going over the mortgage loan, the borrower asked why the lender’s balloon payment calculation was over a thousand dollars higher than what he calculated. Both of them prepared amortization tables using the same principal, monthly payment, and annual interest rate, but there was a discrepancy in the remaining balance. The bank used the 365/360 method (which was only disclosed in the note at closing) while the borrower used either the 365/365 or the 30/360 method.
Since this came out at closing, the buyer understandably signed the note anyway. He was invested in this deal and likely would have accepted the loan had he been quoted a few basis points higher in the first place. Because of its deception, however, the lender has likely lost the confidence and loyalty of its long-standing customer, who does all of his personal and business banking with the lender.
Standard Method of Interest Calculation (30/360)
The standard method of calculating interest is 30/360. Interest is calculated assuming each month has 30 days and each year has 360 days. To calculate monthly interest, you simply divide the annual interest rate by 12 (the number of months in a year) and multiply that by the outstanding principal balance. The monthly interest rate is the same each month.
Example for the first month of interest: 6.00% (annual interest rate) / 12 (number of months in a year) x $400,000 (outstanding principal balance)
Daily Simple Interest Method of Calculation (365/365 and 365/360)
To account for the varying number of days in each month (28-31), some lenders have shifted to daily simple interest calculations. The two popular methods are 365/365 (or actual/365) and 365/360 (or actual/360). The number in the denominator is the number of days the lender uses to represent one year to calculate the daily interest rate. So 365/365 assumes a year of 365 days and 365/360 assumes a year of 360 days.
The 365 in the numerator is just saying that interest will accrue for each and every day that actually lapses, which is why “actual” sometimes replaces “365” in the numerator. As discussed earlier, when the 365/360 method is used, the annual interest rate is divided by 360 but then applied to all 365 days of the year (366 days during leap year). I have yet to see a good justification for this.
The formula used to calculate the interest charge for a given period using daily simple interest is as follows:
Example for the first month of interest using the 365/360 method: 6.00% (annual interest rate) / 360 days (the assumed number of days in one year) x 31 days (the number of days in January) x $400,000 (the outstanding principal balance)
Comparing the Methods
To illustrate the effect of the differing methods, let’s look at a $400,000, 6.00% loan with a term of five years and a monthly payment of $2,400. The loan starts on January 1, 2014.
Regardless of the method used to calculate interest, after five years the borrower will have paid $144,000 ($2,400 x 12 months x 5 years). The balloon payment that the borrower will be responsible for, however, depends on the method for calculating interest (leap year in 2016 accounted for):
Using 30/360: $372,091.99
Using 365/365: $372,145.78
Using 365/360: $374,029.16
The 30/360 and 365/365 methods yield very similar balloon payments. The 365/360 method results in a balloon payment of almost $2,000 more than the other two. This is after only five years.
The Legality of 365/360
The Wisconsin Legislature enacted a statute explicitly making the 365/360 method legal. Wis. Stat. § 138.045 (2013):
Method of calculating interest. Interest on any note, bond, or other instrument computed on the declining unpaid principal balance from time to time outstanding may be computed and charged on actual unpaid balances at 1/360 of the annual rate for the actual number of days outstanding if the use of this calculation method is disclosed in the note, bond, or other instrument. This section does not apply to pawnbrokers’ loans under s. 138.10.
I can only speculate why this was enacted. Even the notes on the drafting request for this section (found here – see “Page 4”) explicitly recognize that the use of the 365/360 method as opposed to the 365/365 method increases the effective interest rate of a 10.00% loan to 10.14%.
Know the Interest Calculation Method
When comparing and choosing loans, you should be aware of how interest will be calculated. If the method is not disclosed in the loan commitment, ask the lender. Even though the difference may seem very subtle, it adds up over the years. Also, if two lenders are offering similar loans, would you not rather choose the lender that is being honest and upfront with you from the start?
If you get to closing and discover that the interest is calculated using the 365/360 method, and it did not appear on the loan commitment, request to have it replaced with the 365/365 or the 30/360 calculation. If the lender claims that its computer system will not allow it to be replaced, request that the interest rate be adjusted to reflect the interest rate that was agreed upon (annual rate divided by 365 then multiplied by 360).
Disclaimer: All content provided on this website is for informational purposes only, it may not reflect the most current legal developments, and it should not be construed as legal advice on any subject matter. You should contact an attorney for advice on any specific legal problem.
Update (July 7, 2016): Comments are now open for this post.
Love your article but your very last sentence is wrong. Your formula is listed backwards. Yours states (annual rate divided by 365 then multiplied by 360).
It should read (annual rate multiplied by 365 then divided by 360).
You really had me scratching my head for a minute because the way you have it written comes up with a lower interest rate instead of a higher rate which contradicts what your whole article is written about. LOL
Thank you for your comment, Judy. The last sentence talks about having the interest rate adjusted to counteract the effect of 365/360 to reflect the interest rate actually agreed upon. To do that, you would need an interest rate that is lower than what was stated. The reason why you would multiply the interest rate by 360 then divide by 365 is because the product of multiplying 365/360 by 360/365 is one. For example, a borrower believes she is getting a 6% interest rate, but finds out at closing that the interest is calculated on a 365/360 basis. To achieve an effective interest rate of 6%, she would need to multiply 6% by 360/365, which would result in a rate of 5.92%. A loan with a rate of 5.92% using 365/360 is very similar to one with a rate of 6.00% using 365/365.
Using the example in the blog post, the balloon payment after 5 years for each situation would be as follows:
6% using 365/365 = $372,145
5.92% using 365/360 = $372,195
As you can see, the difference is only $50 after 5 years (whereas 6% using 365/360 = $374,029). Is a lender likely to make a change at closing? No. But, at the very least, you can make the lender feel uncomfortable for putting you into that position.
Thank you for a great explanation of the process and the rationalization for it as well as how to be leery of those institutions that would prey upon borrowers for such a small gain compared to the loss of respect they could suffer.
You’re welcome, John! Thank you for commenting.
Just closed a loan in Georgia and questioned the lender about the difference in the amortized balance owed at the end of a 10 year note ($5000.00)? The 365\360 basis for interest accrual was the cause. Is this practice legal in Georgia?
I am sorry to hear that, John. Being a Wisconsin attorney, I am not sure exactly where Georgia lands on the subject. Try contacting a local attorney. Best of luck!
This is a great explanation. Thank you very much. I recently encountered this deceptive practice when I realized the fees I am being charged on a monthly basis for “Hard to Borrow” short interest are larger than they should be based on the interest rates my on-line broker tells me I’m being charged. The difference is explained (to the penny) by 365/365 versus 365/360. As my father used to say, “What a racket!” Are brokerage firms required to disclose their use of 365/360 in written documentation in order to legally employ this method of calculating margin interest and hard to borrow interest?
I am glad you found the post to be helpful, Charles. In Wisconsin, the lender would have to disclose the calculation method “in the note, bond, or other instrument.” Many times, the disclosure is not seen until closing.
I just closed Loan in Missouri $850 K ( was quoted 4.45% for 4 year fixed with 20 year amortization) …At closing even the banker was not aware why the payments were not coming as calculated by amortization calculators ..till we find this was 365/360 interest calculation . Its was hidden in the terms ..I reluctantly signed the loan since its just too late to do anything else but I am not a happy customer …I have asked the banker to adjust his loan fees etc to compensate a bit ..but he did not want to do anything ..knowing I had no options……..Not all Banks do this calculation..my loan resulted in $30 /month more in payments and $4000 more in loan balance after our 4 year term.
If you do not know about 365/360, you may not think to ask the lender about the basis for calculating interest before closing. Once you get to closing and discover it in the note, there really is little that you can do. At least you made the lender feel uncomfortable, and you will know to look for it the next time around.
Is the method for constructing an amortization table in the CFR?
Not that I’m aware of.
Very nice article, exactly what I wanted to find.
We closed on a $1M refi today and learned of 365/360 calc (it just seemed a bit odd) 1/2 hr before closing then did some quick research on the web and came across your article. After some discussion with the lender, the promissory note was revised using 30/360 which was in-line with the rate in the term sheet of 4.25% (effective APR actually came to 4.21%!). The experienced commercial banker had never had a client bring this up and spent considerable time on the phone with his credit officer. Furthermore, lender not happy about his reduced APY. My thinking is that most front-line bankers don’t understand this but credit officers do! Great learning lesson for all thanks to you! Thank you!!
You’re welcome, Mike! It’s great to hear you were able to remedy the situation! That certainly makes a considerable difference on a $1 million loan.
I’ve closed CRE loans for many years in the PNW and haven’t seen a 30/360 calculation in over a decade. In my experience at large and small financial institutions, 365/360 is standard practice and it is called out clearly in the loan documents. I have worked with many large developers and it has only been questioned once by one inexperienced borrower. Experienced borrowers know that this is the industry standard and no bank would change the calculation at the last minute to appease a borrower. At large institutions – 365/360 would be a policy requirement.
Thank you for your input, P Emerson. I will start by agreeing with you that 365/360 is common for commercial loans, and it is called out in the note (as required); however, that is generally the only place it appears and is regularly not seen until closing. Often times, borrowers do not read the note that closely, and the amount of time at closing is hardly sufficient to look it over thoroughly, anyway. Also, just because a borrower does not question the method or the note, does not mean the borrower understands what is going on (actually, the opposite is probably more accurate for less experienced borrowers who don’t want to look unprepared or unknowledgeable). There is a reason this post regularly receives around 1,500 views per month (which is a lot for a website that hardly generates content and does little in the way of SEO). The goal of this post is to educate borrowers of this practice, which in my opinion is shady and counter-intuitive, regardless of whether it is “standard practice.” It takes a computer system no more effort to divide by 365 than to divide by 360. Finally, I am genuinely curious as to how you stumbled upon this post. Based on your remarks, I think it is safe to assume you have closed many 365/360 loans, and all of them were without any incident, except for that “one inexperienced borrower.” If true, I’m not sure what would compel you to search for or read about 365/360?
How about if the note for normal monthly payments is calculated using a 365 day year…. but then the lender calculates the prepaid interest, for the month of closing, using a 360 day year? Something does not seem right…..it should be either one way or the other….thoughts?
I’m dealing with this same thing right now. Can’t figure it out…For my month of closing, My “Fee Worksheet” shows prepaid daily interest calculated at 365 day year. The Official Loan Estimate used the 360 day year to calculate first month prepaid.
Confused.
greg,
good article and eye opening,they did it to me ,sadly i did not read the note until today!
p.s i have designed amortization in excel which can calculate any method one can select at ease,
so i think banks are lying as my programme can do it easily so they can do too!
Greg, I would love to share your article on our company blog on our web site. This is an issue that my brokers and I have a great deal of passion about. We very much agree with your analysis of the motivation behind this practice. How do I connect with you to obtain your permission to share it?
Greg
Nice job, lawyers rock!
It took me a while to figure out how my credit union was chapping me on my SBA loan and this helped confirm it. They never disclosed it either. When I asked early in the process they never even got back to me. I saved the emails, but what does it matter.
Many thanks,
Mike
If the HUD closing statement calculates interest through the end of the month using the 365/365 method does that impose a duty on the lender to use the same method over the life of loan? My mortgage note does not contain any reference to the method of interest calculation.
When making two payments at once (as opposed to adding principal to the payment) the mortgage lender is also charging interest in advance according to an amortization schedule. This would seem to be an overcharging of interest. The note does not discuss this at all.
Thanks very much.
Nice article Greg. You articulate this confusing topic quite well. I was a commercial lender for 20 years so I can give you a little perspective from the other side of the table. The practice of the 365/360 interest calculation on commercial loans started over 200 years ago, so this is nothing new. Long before the prevalence of desktop computers, banks had to perform many calculations by hand: generating bills, loan payoffs, etc. To lessen the chances of mistake in their calculations, they adopted the use of the 365/360 interest calculation. After all, if every month had 30 days then the calculations become much easier and the chance of errors becomes less. Today, all banks have core systems that can easily calculate interest in either fashion, but it is not uncommon for a human to have to double-check numbers or manually calculate interest due to a variety of circumstances. So why is it that residential loans are based on a 365/365 method and commercial loans are based on a 365/360 method? Yes, it could be because commercial banks are greedy. It could also be because commercial loans have slightly more complex attributes than residential loans (balloons, due dates on any day of the month, etc). It could be because they have always done it this way and market forces haven’t made them change. It could be because they have tremendous lobbying efforts to “persuade” lawmakers not to pass legislation prohibiting this. Whatever the reason, make no mistake, if banks were forced to move to the 365/365 interest method, they will surely find a way to recoup the lost income. Anyone up for underwriting fees, processing fees, credit report fees, and a $450 fee for a payoff letter?
Greg,
Banks not only do this at closing but know full well they are doing it on closing docs the day of closing. I saw this on my closing docs at noon and questioned my banker who said” I will look into this” His looking into this said it is standard practice but cast me $45 per month on $1.2 mil. over the next 10 years. Simple math is $5,400 but actual payoff is even higher then that. I banker did take the time to look into it as I said but did not get back t me till well after the settlement was completed with any answer. Banks play the games and we have to play by their rules if we want to make money. It would be nice if they were a bit more up front about things like this.
I agree, this is a dirty trick. I just had it happen to me, where I only found out about the bank’s 360 day year 2 days before closes. Very underhanded.
I wonder how they would react if their lawyers charged them on a 59 minute hour.