Interest Accrual Method

Definition of Interest Accrual Method

The Interest Accrual Method in a commercial mortgage refers to the specific mathematical formula or day-count convention used to determine how interest is calculated and charged on the outstanding principal balance of a loan. This method dictates how much interest the borrower owes for a specific period (typically monthly) and determines the total annual interest expense based on the number of days in a year and the number of days in each month.

Detailed Description

In the world of commercial real estate finance, the interest accrual method is a critical component of the loan agreement because it directly impacts the borrower’s effective interest rate and total debt service. While two loans may have the same nominal interest rate, different accrual methods can lead to significantly different payment amounts.

The most common interest accrual methods used in commercial mortgages include:

• 30/360 Method: This is the most traditional method used for fixed-rate commercial loans. It assumes that every month has 30 days and the year has 360 days. This method simplifies accounting for both the lender and the borrower, as the monthly interest payment remains constant regardless of the actual number of days in a specific month.
• Actual/360 Method: This is the most common method for floating-rate and bridge loans. Interest is calculated based on the actual number of days in the month (28, 29, 30, or 31) divided by a 360-day year. Because the numerator (actual days) is approximately 365 while the denominator is 360, this method results in a slightly higher effective interest rate (roughly 1.39% more interest per year) compared to the 30/360 method.
• Actual/365 Method: Under this method, interest is calculated using the actual number of days in the month divided by a 365-day year. This is commonly used by balance sheet lenders and commercial banks. It is generally more favorable to the borrower than the Actual/360 method because the larger denominator results in a lower daily interest charge.
• Actual/Actual: This method uses the actual number of days in the month and the actual number of days in the year (365 or 366). This is often seen in government-issued securities but is less common in private commercial mortgage-backed securities (CMBS).

Why the Accrual Method Matters

The distinction between these methods is vital for commercial investors during the underwriting process. For example, a $10,000,000 loan at a 5.00% interest rate will cost more on an Actual/360 basis than on a 30/360 basis. Specifically, the Actual/360 method results in five or six extra days of interest per year. Over the life of a large commercial asset, these additional interest costs can significantly impact the Net Operating Income (NOI) and the overall internal rate of return (IRR) for the sponsors.

Additionally, the accrual method affects per diem interest calculations during loan closing or payoffs. When a loan is paid off mid-month, the lender uses the specified accrual method to determine the exact amount of interest owed from the first of the month until the day the principal is returned.