Know Your Interest Calculation Method

Know Your Interest Calculation Method

Have you ever negotiated a commercial loan with a bank?  When you go to the bank to sign the documents and you see a reference in the promissory note that interest is being computed on a 365/360 basis, what are the implications of that calculation for you? In short, it means that you will be paying a bit more interest than if interest were being computed on a 365/365 basis or a 360/360 basis. And if you don’t see a reference to the specific method used to calculate interest, you should ask.

Those are the three primary methods used by banks for computing interest, and it appears that the 365/360 basis is becoming the most prevalent method used, especially by larger banks. Banks often do so in an effort to standardize the interest rates based on a 30-day month. Periodically customers have filed law suits to attack this method, but with apparently very limited, if any, success. At the end of the day, your best course of action is to ask for an amortization schedule before you sign the loan documents, perhaps comparing the methods. Then you can see the computations of interest based upon which method is used. And if you don’t like the method, and the bank won’t change, then you may need to find another bank, probably a smaller or community bank to try to obtain an interest calculation method to your liking.

Under the 365/300 interest calculation method, the stated interest rate is multiplied by 365 days with the result divided by 360 days. This will give you your effective rate, which will be a bit higher than if you used other methods. Here is an example: If the stated interest rate is 6.0%, the effective interest rate is 6.083% using the formula above.

In smaller, shorter-term loans, the difference is probably not enough to worry about. But in larger loans, it may be sufficient to warrant further negotiating with your bank or finding a smaller bank that might be more amenable to an interest rate calculation method more to your liking.

Michael W. Margrave


Disclaimer: This blog is for information purposes only. Legal advice is provided only through a formal, written attorney/client agreement.