Looking to take out a new loan but aren’t sure whether it’s a good deal? Let’s break down three commonly used interest rate formulas to see whether you’re being offered a good loan or should look elsewhere.
What Are the 30/360, Actual/360, and Actual 365 Formulas Used For?
These are three formulas commonly used by many commercial real estate lenders. They’re tools to help lenders calculate loans in order to measure risk and the potential return on investment. But you can also use them as a borrower to see how much you’ll pay over time.
Each loan accrual method or calculation can result in significant payment variations over time, especially since some loans can stretch into decades. Knowing which mortgage is best for your needs can help you select the right choice the next time you need to meet with a lender or borrower.
30/360
You can calculate accrued interest for a loan using the 30/360 formula pretty quickly. It’s calculated by taking:
- the annual interest rate proposed by the loan – in this case, it’s 4%
- divide that by 360. This gives you the daily interest rate: 4%/360 = 0.0111%
- next, take the daily interest rate, then multiply it by 30 – this is representative of the monthly interest rate: 0.0111%/30 = 0.333%
As you can see, the 30/360 interest rate formula assumes that there are 360 days a year and 30 days every month, which isn’t strictly true. As such, it’s the least accurate out of all three measures, but it’s the easiest to calculate.
To get this number, you can alternatively take the starting 4% interest rate, then multiply it by 30/360. Basic math reduces this to 1/12. Divide 4% by 12, and you get 0.33%
Either way, you can now take the monthly accrual rate (0.33%) and multiply that by your outstanding balance. Since you’re calculating the lifetime interest of a loan, multiply it by $1 million, and you get $330,000: this is your overall interest accrual amount.
Naturally, some of your monthly payment amount (whatever it is) will go towards that interest, and the rest will be applied to the loan principal. The above chart represents how much you’ll pay in total interest over time, given this accrued interest rate.
Actual/360 (365/360)
Actual/360, also known as the 365/360 rule, is the method most commonly used by banks to calculate interest accrual. You get it by dividing the annual interest rate by 360 to get a daily interest rate. Then you multiply that number by however many days are in the month. Generally, you’ll see larger interest payments due to getting a larger daily rate by dividing by 360 instead of 365 (as you’ll see below).
- Start with the annual interest rate of 4%
- divide that by 360 to get 0.0111% for a daily interest rate
- multiply that by the days in the month, so 30 on average, for a total of 0.333%
This is pretty similar to the numbers we get above, but remember that your accrued interest changes with certain months that have 31 days. So in total, you’ll pay more interest over the entire term of the loan with Actual/360 loans compared to the others.
Consider, for example, that you calculate the loan for January:
- multiply 0.0111% by 31, and you get 0.3441%
- then multiply that by $1 million, and you get $344,100
Ultimately, you pay the most with this accrual method since it has both the highest daily accrual rate and the highest monthly accrual rate. Interest accrual is calculated over the actual number of days in a given month.
Actual/365
You can calculate the Actual/365 formula by taking the annual interest rate, then dividing that interest rate by 365 (the total days in a typical year). You’ll then multiply that number by how many days are in your current month. This can also accommodate months like February, which only has 28 days in a month. Actual/365 is also sometimes called 365/365.
So:
- Take the annual interest rate of 4%
- Divide that by 365 to get 0.011% (rounded)
- multiply that number by how many days are in the month. Take 30 is an average and you get 0.3287%
- of course, then multiply this by $1 million, and you get $328,700
You’ll notice that you have a smaller daily interest rate (since the above value was rounded). However, you end up paying a slightly higher amount of interest over the whole year since some months have 31 days instead of 30.
30/360 vs Actual/360 vs Actual/365 Comparison
|
Lender |
Loan Amount |
Interest Rate |
Interest Rate Formula |
Actual Interest Rate |
Total Paid Interest |
|
First |
$1 million |
4% |
30/360 |
4% |
$214,942 |
|
Second |
$1 million |
4% |
Actual/360 |
4.058% |
$218,341 |
|
Third |
$1 million |
4% |
Actual/365 |
4.003% |
$215,166 |
As you can see, the minor differences between each interest rate formula result in variations in interest paid on the order of several thousand dollars, even though the loan amount is the same, and the beginning interest rate is also identical. Let’s break down each loan type now.
Which Method Is Most Common?
Most banks use the actual/360 method because it helps standardize daily interest rates throughout the year. Another reason they prefer to calculate over 360 days instead of 365 is that the daily interest rate is slightly higher. Over the course of a 30-year mortgage, you will end up paying a few hundred extra dollars with the 365/360 method.
Which Interest Calculation Method Is Best?
The overall results of this analysis are pretty clear. You’ll generally pay the least with a typical 30/360 loan formula, even over the Actual/365 interest calculation method, since the latter has you pay a little more interest over the entire year. This means that most borrowers will want to go with the loan that requires them to pay the least interest over time.
However, the Actual/365 interest rate formula could be advantageous if you want a loan agreement that has a lower daily interest rate. This may make monthly payments a little easier for some parts of the year. Just remember that the bill will eventually come due, and you’ll have to pay a bit more than if you used the first formula.
30/360 vs Actual/360 vs Actual/365 Bottom Line
While the differences between 30/360 and Actual/360 and Actual/365 are not particularly large, they can result in a difference of thousands of dollars over time. And the difference between 30/360 vs Actual/360 can be even more substantial if you need loans for even higher amounts of money (such as loans into the millions of dollars). Use this guide as a tool to help you get the best loan the next time you need to stop by a lender’s office.
Good luck, and remember to ask questions of your loan agent if they aren’t being clear!