Do all lenders use the same method to calculate daily interest?

I’m comparing personal loan offers and noticed that the monthly interest charges vary significantly, even with similar principal amounts and annual rates. Some lenders specify daily compounding, others mention simple daily interest, and one referenced a 360-day year versus a 365-day calculation in their fine print. Since I’m trying to understand the true cost and choose the most cost-effective option, do all lenders use the same method to calculate daily interest, or are these discrepancies standard due to industry practices or product types?

No, not all lenders use the same method to calculate daily interest. The specific method varies significantly between lenders and is primarily determined by:

1. Loan Type and Contract Terms: The loan agreement itself specifies the calculation method. Promissory notes and loan contracts explicitly detail how interest accrues.
2. Compounding Frequency: This is the most critical factor. The frequency at which unpaid interest is added to the principal balance determines the effective interest rate and the daily method:
   • Daily Compounding: Unpaid interest is added to the principal balance every day. Interest for the next day is calculated on this new, increased balance. Common for credit cards, personal lines of credit, some student loans, and mortgages using specific methods like Actual/365.
   • Monthly Compounding: Unpaid interest is added to the principal balance once per month. Daily interest accrues based on the starting principal for that month until the compounding date occurs. Common for fixed-rate mortgages and some installment loans.
   • Annual Compounding: Unpaid interest is added to the principal balance once per year. Daily interest accrues based on the starting principal until the compounding date. Less common for standard consumer loans.
3. Day Count Convention: The method used to calculate the number of days between payments (or for daily accrual) differs:
   • Actual/Actual: Uses the actual number of days in the period and the actual number of days in the year (365 or 366). Common in mortgages and some corporate loans.
   • Actual/360: Uses the actual number of days in the period but assumes a year has 360 days. This results in higher daily interest and more total interest paid over the life of the loan compared to Actual/365. Common in commercial loans, some mortgages, and treasury bills.
   • Actual/365 (Fixed): Uses the actual number of days in the period and assumes a year always has 365 days (leap year ignored). Common in some installment loans and mortgages.
   • 30/360: Assumes each month has exactly 30 days and a year has 360 days. Simplifies calculations but doesn’t reflect actual calendar days. Common in corporate bonds, some mortgages, and other fixed-income securities. Variations exist (e.g., 30U/360, 30E/360).
   • 365/365: Uses the actual number of days in the period and assumes a year always has 365 days. Similar to Actual/365(Fixed) but sometimes specified differently. Less common.
4. Annual Percentage Rate (APR) Application: The APR is the nominal annual rate used as the starting point for daily calculations. Lenders divide this APR by different factors to get the daily rate:
   • APR / 365: Used when the day count is Actual/365 or 365/365.
   • APR / 360: Used when the day count is Actual/360 or 30/360.
   • APR / 366: Used in leap years for methods like Actual/Actual or Actual/365 if leap day is considered.
   • Other factors might be used in complex financial instruments.

Examples of Different Methods:

• Credit Card: Typically uses daily compounding with a Daily Periodic Rate (DPR) = APR / 365 (sometimes 360). Applies the DPR multiplied by the average daily balance over the billing cycle.
• Fixed-Rate Mortgage: Often uses monthly compounding. Daily interest accrues based on the outstanding principal balance at the beginning of the month. Interest for the month is calculated using the monthly rate (APR / 12) and added to principal at month-end. The specific accrual method within the month might be Actual/360, Actual/365, or 30/360.
• Business Loan (Line of Credit): Often uses daily compounding with Actual/360. Daily interest = Outstanding Balance x (APR / 360). This method results in slightly higher interest payments than Actual/365.
• Treasury Bill: Uses simple interest calculated with Actual/360. Interest = Principal x Rate (Discount Rate) x (Days to Maturity / 360).
• Installment Loan (Auto, Personal): Often uses simple interest calculated on an Actual/365 or Actual/360 basis. Daily interest = Outstanding Balance x (APR / 365 or APR / 360). Compounding frequency might be monthly or less frequent.

Conclusion: Because lenders choose different compounding frequencies and day count conventions based on the loan type, contract terms, and internal practices, the method used to calculate daily interest is not standardized across all lenders. Borrowers must carefully review the loan agreement to understand the specific accruement method being used. Note that loans quoted with the same nominal APR can result in different total interest paid due to these different calculation methods.