Just got a loan, but do you really know how your lender calculates your monthly payment and amortization schedule? It’s not as simple as you think. In fact your lender may be calculating your payment differently than you expect or know.

A few years ago there was a lot of talk about payment methodology. People were talking about 30/360 payments, actual/360, actual/365 and all sorts of different methods to calculate your monthly payment. From my perspective these various payment methods were just ways for lenders and brokers to hide the real deal and fool borrowers.

For most of the 20^{th} century, most lenders used a 30/360 calculation in determining your monthly payment. They assumed every month had 30 days and each year had 360 days. This allowed for easy calculation of interest rates and amortization schedules. A 30/360 calculation is listed on standard loan constant charts and used by your calculator or computer in determining mortgage payments.

During the mid 1990’s the Wall Street lenders started using actual/360 or actual/365 payments in mortgages. These are methodologies used in some other debt instruments, particularly bonds. They call for the borrower to pay interest for the actual number of days in a month. This effectively means that you are paying interest for 5 or 6 (on a leap year) additional days a year. By doing this a lender can quote you a lower spread and rate on a transaction but actually collect the same or a greater amount of interest each year. The difference between actual/360 and actual/365 is the monthly payments not the overall yearly interest charge. Both calculations charge you interest on the actual days in a month, but on the 30/365 loan your monthly payment is increased by the extra 5 (or 6) days of interest.

Today you don’t hear much about actual/365 and most loans are either actual/360 or 30/360. On an actual/360 loan the payments are the same as on a 30/360 loan, but the amortization schedule is adjusted to account for the difference in interest. Therefore, your balloon balance for an actual/360 loan would be slightly higher than for a 30/360 with the same payments. An actual/360 loan will have a balloon balance approximately 1% to 2% higher than a 30/360 loan with the same payment. At current rates of about 6% the difference between an actual/360 loan and a 30/360 loan translates into about 8 Bps. So in order to compare a 30/360 loan to actual/360 loan you should subtract 8 Bps or so from the 30/360 quote to put it in the same terms as an actual/360 quote.

While the Wall Street conduit lenders started this trend, the Freddie Mac and Fannie Mae multifamily groups followed quickly behind. Freddie and Fannie found they were losing deals to conduit lenders because of the quoted lower spread and its lower payment even thought he effective interest rate charge was the same or in some cases higher. They started offering actual/360 loans in addition to 30/360 and today you can request a loan using either calculation. Though the conduits are still on life support you still see most Freddie and Fannie quotes being offered as actual/360. This is because it makes the rate sound better, lowers the monthly payment and makes it more likely the borrower will go ahead with the loan. However, this is not always the case so ask your lender what calculation method they are using.

While most Freddie and Fannie loans are being quoted as actual/360 this is not true of many other lenders. FHA/HUD loans are quoted as 30/360 as are most life insurance company loans and almost all bank loans. Therefore when comparing a Freddie or Fannie loan to a quote from another lender you must adjust for the payment methodology.

What’s the better methodology? It really does not matter as long as you understand the difference. Some people prefer actual/360 because it’s effectively a longer amortization schedule. I personally prefer 30/360 because I can calculate the payment myself on my trusty HP 12c. On an actual/360 loan I need an excel spreadsheet and still need to ask the lender for a printout of the actual payment and amortization schedule to make sure I am correct. Whichever you prefer just remember to ask what payment methodology your lender is using so you can properly evaluate your loan quotes.