Interest Calculation Method

Definition of Interest Calculation Method

In the context of commercial mortgages, the Interest Calculation Method is the standardized mathematical formula used by lenders to determine the amount of interest accrued on a loan balance over a specific period. Unlike residential mortgages, which typically use a uniform calculation, commercial contracts may employ different conventions for counting the number of days in a month and the number of days in a year. These variations directly impact the effective interest rate and the total debt service paid by the borrower.

Detailed Description and Common Methods

The calculation method is a critical component of a commercial loan agreement because it dictates how the stated nominal interest rate is applied to the outstanding principal. The most common methods used in commercial real estate finance include:

• 30/360 Method: This method assumes that every month has 30 days and the year consists of 360 days. It is often used in Agency loans (such as Fannie Mae or Freddie Mac) and CMBS (Commercial Mortgage-Backed Securities). It provides a consistent monthly payment regardless of the actual number of days in a calendar month, making it simpler for accounting and bond pricing.


• Actual/360 Method: This is the most prevalent method for bank-held commercial loans and bridge financing. Interest is calculated based on the actual number of days in the month (28, 29, 30, or 31) divided by a fixed 360-day year. Because there are 365 or 366 days in a year, this method results in the borrower paying approximately 5 to 6 extra days of interest per year compared to the 30/360 method. This effectively increases the lender's yield and the borrower's total cost of capital.


• Actual/365 Method: Under this convention, interest is calculated using the actual number of days in the month divided by the actual number of days in the year (365 or 366). This is considered the most mathematically accurate representation of time and is common in certain government-insured loans and specific private lending structures.

The Financial Impact on Borrowers

While the difference between these methods may seem negligible on a small scale, the financial impact is significant in large-scale commercial transactions. For example, on a $10,000,000 loan with a 6% interest rate, the Actual/360 method generates roughly $8,333 more in annual interest than the 30/360 method. Commercial borrowers must carefully review the Promissory Note to identify which method is being utilized, as it alters the "all-in" cost of the loan even if the nominal interest rate remains the same.

Lenders prefer the Actual/360 method because it maximizes the Internal Rate of Return (IRR) on their capital. Conversely, borrowers should be aware that a loan quoted at a specific rate using Actual/360 is functionally more expensive than a loan quoted at the same rate using a 30/360 or Actual/365 basis.