Evaluating Interest Calculation Methods

Lenders have a few choices on how to calculate the interest charged to their borrowers. In this article, we will explore the cost differences and the effective rates of three common types of interest calculations: 360 / 360, 365 / 360 (Bank Method), and the 365 / 365 (Stated Rate Method). The first number represents the number of days in the compounding period for which interest is to be charged. For 360, interest will only be charged on 360 days of the year. If the loan calls for a monthly compounding period, interest will be charged on a 30 day month regardless of the number of actual days in the month. For 365, the loan calls for interest to be charged on the actual number of days in the compounding period. The second number represents the number of days in the year to divide the Annual Percentage Rate by. For 360, the stated interest rate is divided by 360. For 365, the stated interest rate is divided by 365.

To illustrate the differences, let's use an example lending commitment. The table below sets out our assumptions:

ASSUMPTIONS
Loan Commitment$1,000,000
Constant Monthly Payment$5,368.22
Interest Rate5.00%
Amortization Periods360
Term Periods360

When we amortize each interest type to maturity and sum up the total interest that would have been paid over the life of the loan, we find that the lifetime interest paid for each type in the table below:

INTEREST PAID OVER THE LIFE OF THE LOAN
360 / 360365 / 360365 / 365
$932,556$970,016$934,095

The most advantage interest calculation type to the borrower is the 360 / 360 followed closely by the 365 / 365. The 365 / 360, when amortized over the 360 term periods, will cost the borrower an extra $37,460 (3.746% more) when compared to the 360 / 360 interest type. Next we will determine at what effective rate will cause each alternative to have the exact same lifetime interest cost. The results are shown in the table below:

Effective Interest Rate
360 / 360365 / 360365 / 365
5.00000%4.92853%4.99698%

If a borrower is evaluating a financing proposal from a lender which charges interest the actual number of days dividing the stated interest rate by a 360 day year (365 / 360), the stated interest rate must be equal to or lower than 4.92853% to make it comparable or advantageous to the borrower when compared to the 360 / 360 interest calculation type. The 365 / 365 type is virtually identical to the 360 / 360 interest calculation type.

In this example, we used a 30 year amortization term period. If the loan calls for a shorter term, of say 10 years, the effective interest rates remain the same and the interest cost of the 365 / 360 loan will again cost the borrower an extra 3.746%.

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