Day count conventions are a fundamental accounting concept for anyone managing loans, whether you’re a borrower or a lender. From bonds and loans to other derivative contracts, the method you choose to apply interest to the days and months of a year can significantly affect interest calculations and the overall returns on an investment.
This post aims to demystify the concept of day count conventions and help you determine which convention to use for loans, enabling you to make informed decisions.
Let’s start with a definition.
What are day count conventions?
Day count conventions are rules used to determine the number of days that interest accrues between two dates on bonds, loans, and other financial instruments.
These conventions establish a standard method for calculating interest accrual over different periods. This standardization ensures consistency and fairness in the way interest is computed for any investment earning interest over time.
There are several day count conventions, each with its own method of calculation (more on this in a moment). The convention you choose will influence how interest accruals are determined and ultimately impact the total amount of interest earned or paid.
However, despite how important this factor is, many borrowers and lenders are unaware of the different approaches to interest calculation. Let’s look at the key considerations for borrowers and lenders.
Borrower considerations
As a borrower, you can’t decide what day count convention the lender offers. But it’s still important to understand the impact of different day count conventions to help you choose between loan options.
If you don’t know what convention a lender used, you as a borrower won’t be able to create accurate schedules and automate your journal entries. However, by understanding this concept, you can determine which convention lenders are using on existing loans if they don't clearly state it.
Lender considerations
As a lender, you’ll want to be deeply familiar with the different day count conventions as this will impact the cumulative interest income you collect on a loan. Lenders can determine which conventions they’ll offer to make a loan more (or less) attractive to borrowers and increase how much cumulative interest you’ll collect over the loan term.
Types of day count conventions
Let’s go over the most popular day count conventions used by lenders.
30/360
The 30/360 convention calculates the daily interest using a 360-day year and then multiplies that by 30 days (standardized month). Interest is only applied to the first 30 days of the month. This convention recognizes 3 days' worth of interest on February 28.
360/360
The 360/360 convention calculates the daily interest using a 360-day year and then multiplies that by 30 days. These 30 days of interest are applied evenly across the actual days in the month pro rata (i.e., in equal proportion). This convention recognizes 30 days of interest pro rata across 28 days in February.
30/365
The 30/365 convention calculates the daily interest using a 365-day year and then multiplies that by 30 days. Interest is only applied to the first 30 days of the month. This convention recognizes 3 days' worth of interest on February 28.
Actual/360
The Actual/360 convention calculates the daily interest using a 360-day year and then multiplies that by the actual number of days in each period. The total interest varies from month to month.
Actual/365
The Actual/365 convention calculates the daily interest using a 365-day year and then multiplies that by the actual number of days in each period. The total interest varies from month to month.
Actual/Actual
The Actual/Actual convention 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. The total interest varies from month to month.
Day count convention interest variance examples
Now that you have an idea of how each day count convention works, let’s run through an example to illustrate how the choice of day count convention can impact interest accrual.
Let’s say you’re deciding between a 30/365, a 30/360, and an Actual/360 interest loan. For this example, let's assume a $1,000,000 loan balance, an even 5% annual percentage rate (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 different conventions.
Principal balance * APR% * Day count convention = Monthly interest
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 because it assumes more days in the year (lower daily interest) and 30 days rather than the 31 days January has. On the other hand, Actual/360 assumes fewer days in the year and the actual number of days in January (31), which results in notably higher interest recognition in comparison.
How to identify conventions used
As a borrower, you may wonder what day count convention your current loan uses. Often, the easiest way to determine what convention was used is to check your loan statement or reach out to your lender and ask them directly. But if this isn’t an option, you can try to recalculate the interest you paid for a given month.
Use the above examples and the following monthly interest formula as a guide.
Principal balance * APR% * Day count convention = Monthly interest
Rearranging terms, we can back into the day count convention as follows:
Monthly interest / Principal balance / APR% = Day count convention
Using the information in the example above, let’s assume you as a borrower know the loan balance at the beginning of January was $1,000,000, the APR on the loan is 5%, and you paid $4,166.67 in interest in January. Without knowing the day count convention, you can back into the one used by the lender by calculating the following:
$4,166.67 / $1,000,000 / 5% = .08333 (which is equal to 30/360)
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’ll want to include February in your testing.
Simplify loan accounting with NetLoan
Understanding how to apply day count conventions in your manual loan management processes is great, but automating these processes is even better.
NetLoan offers a comprehensive solution for both lenders and borrowers seeking to streamline their loan management processes within NetSuite. This intuitive tool simplifies and automates your loan accounting, saving valuable time and reducing the risk of manual errors.
NetLoan requires users to select a day count convention on the Loan Types level. The day count convention determines how a given APR is applied to the days and months of a year. Since this is a vital part of a loan that has a significant impact on the amortization schedule, you’ll want to carefully select the correct convention so NetLoan can book the correct entries. Once you do so, NetLoan will take care of the rest.
Want to see NetLoan in action? Request a demo to discover how NetLoan can simplify your loan processes.
