Borrower Beware: The Actual/360 Calculation

Recently, a long-time client of ours inquired as to the effect of the actual/360 calculation applied on his recent CMBS loan, and it was a question that raised a few issues I thought I’d like to share with you all in hopes it might be helpful. 

As you may recall from your B-School or RE-school finance classes, amortization is a way of spreading debt over a defined time period. Your own home loan (if you have one) likely has a structure like a “30/30”, which is a 30 year loan term spread over 30 years of amortization. It's a fully-amortized loan, meaning at the end of its 30 year term the balance remaining will be zero. It’s somewhat rare to see this type of structure in CRE, though many of our life insurance company correspondents offer this structure.

More often than not, a typical CRE loan will be a "balloon" loan structure, where a loan may be amortized over the same 30 years, but the loan term is only 10 years – 30 year money due in 10, or sometimes “30/10” or "10/30" for short. 

Now, all this is basic stuff but what is often overlooked is the method that is used to calculate amortization. Why might we care about this? Because, it can greatly affect the amount of interest a borrower will pay over the life of the loan and the size of balloon payment due at maturity, both important factors when weighing financing options.

Specifically, the question we address here is: “which day-count convention is used in calculating my interest?”

Two most common types of day-count conventions in the US – 30/360 and the Actual/360

The first one is the most common and easiest to grok, and it’s a calculation with which you’re likely to be implicitly familiar. The 30/360 calculation is the one deployed by your classic financial calculator, amortization schedules, bonds, banks and life cos. It means the amortization schedule is calculated based on a static 30-day month and a 360-day “bankers” year. Or, more accurately, 30 is the number of interest-bearing periods per payment calculation and 360 is the number of total periods per year, with annual interest often split into 12 equal payments.

The advantages of the 30/360 include stable interest + principal payments each month, and general ease of use that comes with its commonality and accessibility.

The other is oft-quoted and just as oft-misunderstood: the Actual/360 convention. Used primarily in CMBS mortgage structures, the Actual/360 calculation shares the same basic calculation as the 30/360 method but with one important distinction: interest is calculated based on the actual number of days within each month, while still on a 360-day year. This amounts to 5 extra days paid interest per year (or 6 days in case of a leap year). What’s more, the way the monthly payment of “Principal + Interest” is tabulated can affect principal reduction over the loan’s life as well.

Let’s compare two examples…

Example A – a $5,000,000 principal loan amount, @ 5% interest per annum, 10 year term/ 30 year amortization, even monthly payments calculated via 30/360

Example B – a same as example A, but calculated via Actual/360

As you can see, the delta includes $44,574.43 in additional interest paid using the Actual/360 method, which corresponds to an equal amount of further principal reduction not enjoyed over the term.

Now, in some ways this is an unfair comparison as loans that use the Actual/360 can be more competitive on rate, so things are not equal. But suffice to say one should be aware of the difference in day-count conventions when sizing up a real-estate deal.

Some other notes:

-         Actual/360 calculations depend on defining a start date for the loan term as the number of days in each period changes accordingly. The above example used 3/1/2014 as a loan term start date. If, instead, the loan didn’t begin until June 1st of that year, the resulting delta relative to the 30/360 would be less: $44,186.19

-         In the above example, we assumed the monthly payments were even throughout the life of the loan, which is the most common set up. In the Actual/360 example, this would cause the principal portion of the payment to be lower on months with more days/higher interest, and visa-versa. But, some lenders instead keep the principal steady throughout the life of the loan, so therefore the combined principal + interest monthly payment would vary each month up or down based on the number of days in that period.

In summary, know what you’re signing and request a loan repayment schedule prior to close if you have any doubt. We can run through any scenarios you might have on your next transaction and give you the data to make an informed decision.

Happy Hunting!

Cody Charfauros is a Vice President of Commercial Mortgage Banking with Barry Slatt Mortgage and lives in San Diego, California with his wife and two crazy boys.