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What Is Exact Interest?
Malcolm Tatum
Malcolm Tatum
Exact interest is a process of calculating the interest on a debt based on a 365 day year. This is in contrast to other methods that may base the interest on other time periods, such as a 360 day basis. Understanding whether the lender uses an exact interest model is important to understanding exactly how a given rate of interest is applied to the outstanding balance, which in turn can help applicants determine the true value of that interest rate.
The structure of exact interest is slightly different from ordinary interest. Ordinary interest is based on the assumption of thirty days in each month of the calendar year. This leads to a situation where the application of the interest rate is based on 360 days. In contrast, exact interest allows for the application to relate to the actual number of days found in the calendar year, and not an average number of days per month within that year. Proponents of this approach consider this type of interest to be more accurate, since it is based on specifics and not on the use of an average.
While the difference between exact interest and ordinary interest creates only a small ratio, that ratio can become quite significant as the amount of the loan issued by the financial institution increases. This means that someone who is purchasing a used car and financing it for a period of two years will probably not see much of a difference, no matter which method is used. At the same time, a corporation that is taking out loans to build a new corporate headquarters will be very interested in whether the terms allow for the application of ordinary or exact interest, since the amount of interest paid on that large loan with terms of twenty to thirty years could be considerably higher, depending on which approach is used.
In general, exact interest is usually applied on investments such as government sponsored bond issues or treasury bills. Ordinary interest is more commonly used with personal loans, mortgages, and corporate bonds. Still, the regulations that govern lending and investment practices within different countries allow for some leeway in determining how to apply interest to the principal of the investment. For this reason, it is important to determine which method is identified in the contract governing the transaction, and determine how much interest will be due as a result. That final result may indicate that seeking out a similar deal that calculates interest based on a different method would be a good idea.
Malcolm Tatum
After many years in the teleconferencing industry, Michael decided to embrace his passion for trivia, research, and writing by becoming a full-time freelance writer. Since then, he has contributed articles to a variety of print and online publications, including SmartCapitalMind, and his work has also appeared in poetry collections, devotional anthologies, and several newspapers. Malcolm’s other interests include collecting vinyl records, minor league baseball, and cycling.
Learn more...
Malcolm Tatum
After many years in the teleconferencing industry, Michael decided to embrace his passion for trivia, research, and writing by becoming a full-time freelance writer. Since then, he has contributed articles to a variety of print and online publications, including SmartCapitalMind, and his work has also appeared in poetry collections, devotional anthologies, and several newspapers. Malcolm’s other interests include collecting vinyl records, minor league baseball, and cycling.
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Discussion Comments
It is always advisable to know the type of interest rate your loan will attract. Some people have ended up in debt while trying to build an enterprise because of the loans they took.
It's always advisable to check with the more financially legitimate before making a hasty decision that could turn your dream of becoming the next Microsoft into a poverty and debt empire.
@indigomoth - See, you make good points about the interest, but in most cases, as it says in the article, whether or not they are calculating with exact interest or not isn't going to make much difference financially.
What makes a difference to me is whether the bank or finance company is up front about how they calculate their interest.
If they say that they aren't using exact interest to calculate and carefully explain what that means, I will give them a pass. Likewise if they are using exact interest, because that's obviously going to be easy for me, a non-banker, to understand.
But if they try to sneak it past me, I'm not going to be happy about it. What else will they try to sneak past me in that case?
There are all kinds of ways you can end up being done by your bank.
But, this is one of the little ways you can check whether they are worthy of your time and money.
@bythewell - I have heard of people who have ended up with student loans of over 100,000 dollars. Which is certainly nothing I could pay off in a hurry, and not all of these people have high paying jobs to help them along.
When you think about that 100 days over twenty years, that can be a lot of money, considering the rather high rates of interest people end up paying on student loans.
To be honest, with a loan of that amount, I'm not sure I would ever be able to pay it off, I'd be forever chipping away at the interest. Getting as good a deal as possible on the interest is vital, which is one of the reasons you should look at whether the organization is giving you estimates based on exact interest or not.
You should always check on this kind of thing before you take out a loan. People don't realize how the extra few days can add up, but it really does, particularly if it's a large loan, or done over a long period of time.
Like, for example, with a house loan, or even with student loans if they are large and taken out for a long time (I've known people still paying off their loans 20 years after getting their degree, so it is definitely possible for this to be an issue).
I mean, if you look at 20 years worth of 5 day periods, that's 100 days of extra interest you'll have to pay off.
It's definitely something to look at when you are applying for a loan, or maybe looking to refinance an existing one.
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