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When I first joined TimeValue Software, it took me a while to understand the difference between Daily (compounding) and Exact Days. Both methods calculate interest each day but that is where the similarity ends.
The Daily method compounds interest every day. This is what the IRS does on any money that you owe them. Any unpaid interest gets calculated and added to the balance every day and then the next day it does the same thing. Here is more of a technical description.
A Daily compound period calculates interest for each day by multiplying the balance by the Daily Rate. This interest is then added to the balance and compounded each day. The Daily Rate is determined by dividing the Nominal Annual Rate by the Year Length (e.g., 360, 364, or 365).
The Exact Days method can be used with either compounded interest or simple interest (no compounding) calculations. With Exact Days, you multiply the balance times the interest rate times the number of days between events, and then divide by the year length to calculate the interest. Your interest expense will tie out to the number of days in the month/period. When you have compound interest, any unpaid interest will be capitalized when you have an event and added to the balance. Here is a more technical description.
Interest for each period is calculated at the Daily Rate times the number of days in a period. If payments are monthly, the calculation is based on the number of days in each month. For example, the interest charge for March (31 days) will be greater than the interest charge for April (30 days).
The question is what method do you use? In my experience, I have seen many loans between private parties that use simple interest with Exact Days to calculate the interest. This can make the interest calculation pretty easy to verify as you just need the number of days to calculate interest at any point in time. Daily compounding is rarely used in any consumer or business loan.
With TValue, you have the option to use compound interest (Normal) or simple interest (US Rule) combined with any of 13 different periods including Daily and Exact Days.
