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.
