NetLoan - Day Count Convention Best Practices

Day Count Convention Best Practices

NetLoan requires users to select a day count convention on the Loan Types level. The day count convention determines how a given annual percentage rate (APR) is applied to the days and months of a year. Since this is a vital part of a loan that has a large impact on the amortization schedule, you will want to ensure you carefully select the correct convention so NetLoan can book the correct entries. Despite how important this determining factor is, many borrowers and lenders are unaware of these different approaches to interest calculation. This article will help you determine which day count convention is the correct one for the loans in your current portfolio and enable you to make wise decisions moving forward.

Borrower Considerations

As a borrower, you will not be able to decide what day count convention that is used. Rather you are at the mercy of the day count convention offered by the lender. It is still important to understand the impact of various day count conventions due to the decision-making impact this will have when deciding on which offered loan options to select. Equally important is the know-how to determine what convention was used on a loan you have already entered into if this is not clearly stated. Note that without knowing what convention was used by a lender, a borrower will not be able to recreate accurate schedules and you will therefore not be able to automate your journal entries.

Lender Considerations

If you are a lender, you will want to be deeply familiar with the different day count conventions as this will impact the lifeblood of your company which is the cumulative interest income you will collect on a loan. Lenders are in a position to determine which conventions they will offer to make a loan more or less attractive to borrowers, increasing how much cumulative interest will be collected over the loan term.

Day Count Conventions Available

The options are countless but we will highlight the most popular conventions we have seen and currently support with NetLoan.

30/360
Calculates the daily interest using a 360-day year and then multiplies that by 30 (standardized month). Interest will only be applied to the first 30 days of the month. Recognizes 3 days worth of interest on February 28th.

360/360
Calculates the daily interest using a 360-day year and then multiplies that by 30 (standardized month). These 30 days of interest will be applied evenly across the actual days in the month pro rata. Recognizes 30 days of interest pro rata across 28 days in February.

30/365
Calculates the daily interest using a 365-day year and then multiplies that by 30 (standardized month). Interest will only be applied to the first 30 days of the month. Recognizes 3 days worth of interest on February 28th.

Actual/360
Calculates the daily interest using a 360-day year and then multiplies that by the actual number of days in each time period (total interest varies from month to month). 

Actual/365
Calculates the daily interest using a 365-day year and then multiplies that by the actual number of days in each time period (total interest varies from month to month). 

Actual/Actual
Calculates the daily interest using the actual number of days in the year and then multiplies that by the actual number of days in each month (total interest varies from month to month and year to year). 

Convention Interest Variance Examples

Let's say you are determining whether to choose a 30/365, a 30/360, or an Actual/360 interest loan and run through some examples. For this example, let's assume a $10,000 loan balance, an even 5% APR, and that the year in question is not a leap year. 

Here are the interest calculations you would follow when determining your interest expense/income for January using the three conventions.

30/365: $1,000,000 * 5% * (30/365) = $4,109.59

30/360: $1,000,000 * 5% * (30/360) = $4,166.67

Actual/360: $1,000,000 * 5% * (31/360) = $4,305.56

As you can see 30/365 results in the lowest interest recognized since it assumes more days in the year (lower daily interest) and 30 days rather than the 31 days January actually has. Whereas Actual/360 assumes fewer days in the year and the actual days in January (31) which results in notably higher interest recognition in comparison. 

How to Identify Conventions Used

• As a borrower, the easiest way to determine what convention was used is to reach out to your lender and ask them directly. 
• If you have access to loan statements the day count convention should be listed towards the top. 
• If this is not the case you can resort to trying to recalculate the interest you paid for a given month. You can use the above examples and the following calculation monthly interest formula as a guide.
  
  Principal balance * APR * ( day count convention ) = monthly interest
  
  Once you can tie out 2-3 months of interest using one convention you can be sure that this is the convention your lender used. Note, that different conventions handle February's 28 days differently so you will want to include February in your testing.

Our Take Aways

As shown in the above examples, NetLoan will not be able to post the correct entries if an incorrect day count convention is selected due to the interest variances this would cause. Not all conventions will vary this significantly on a one-month basis but applied over the loan term this may end up being much more material. Additionally, we learned that certain day count conventions cause higher or lower interest accruals and due to this the decision-making on what day count conventions are beneficial to you will vary depending on whether your business is a lender or borrower. Lastly, there are different methods you can use to determine the day count convention that was used that include asking your lender, checking the loan statements, and trying to recalculate the interest for a month.