My mortgage balance is WHAT!?

From the desk of Charlie Craig:

I was recently working with a client that had purchased a small shopping center listing of mine nine years ago. My client financed the acquisition through a conduit and the 10-year term of the loan was expiring in a year. I ran financing projections for the client prior to closing and these projections included loan payments as well as loan amortization.
My client requested that the lender provide a projected loan balance at the expiration of the ten-year note. The loan amortization period was 25 years. The lender projected a loan balance that was approximately $33,000 higher than my projection based on initial loan of $1,461,000. My client asked me to help him account for this discrepancy.
I recalculated the mortgage balance with several different mortgage balance software programs available on line and the result was the same. My projected mortgage balance calculation continued to be approximately $33,000 lower than the lender.
The lender eventually provided a breakdown of the monthly loan payments including interest, principal reduction and daily interest charges. The interest charges seemed high and offsetting principal reduction low, given a fixed 10 year rate of 9.19%. It turns out that my client was being charged daily interest based on a 360 day year; however, the 360 day daily interest charge was being applied to the actual number of days in the calendar year, typically 365. This methodology resulted in an effective interest rate of 9.32% and a reduction of principal amortization, given the monthly fixed loan payments.
When this methodology was relayed to the lender, her response was “this is consistent with your loan document and a standard practice in the commercial real estate mortgage industry.” I reviewed the loan document, and the note clearly stated an initial loan balance of $1,461,000 and annual interest rate of 9.19% fixed for 10 years, a 10 year term and a 25 year amortization. The annual monthly loan payments of $12,451.31 stated in the note matched the calculation based on the standard 360 day monthly payment schedule.
However, buried in the agreement was the following language “Interest on the principal sum shall be calculated on a 360 day year, and shall be charged on the actual number of days in the month”
The issue is the months typically total 365 days a year. Over a compounding period of ten years, this overcharged interest resulted in an additional $33,000 to the mortgage balance.
The lender balked at any insinuation that this practice, which resulted in an effective rate of 9.32%, was misleading or unethical.
No one, including the borrower’s lawyer, mortgage broker and me understood or challenged this language.
And, apparently, the lender was right about this practice being a wide spread industry standard. Based on my conversations with commercial banks, a large majority of banks follow this practice, which results in commercial borrowers being overcharged relative to the interest rates they were quoted. It is very rare that any borrowers challenge this practice. Residential borrowers, in contrast, are protected from the activity via Truth in Lending Laws.
To be fair to the commercial banks I spoke with, they initially did not understand the ramification of a 360 day year per diem interest charge applied to a 365 day calendar year.
My advice? Make sure you are quoted an interest rate based on a 360 day year applied to 360 actual days or 365 day simple interest before committing to any lender. And review your loan document to make sure your interest calculation is correct before signing. Otherwise, you may be in for a very unpleasant surprise when your loan is due.
Charlie Craig (Charlescraig@dunham-group.com) is a Partner at NAI The Dunham Group.