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.