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.