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November 21, 2014
Calculating Interest on Commercial Loans: Recent Legislation Expressly Permits Illinois Lenders to Use the "365/360" Method
Lenders throughout Illinois can breathe a sigh of relief now that Governor Pat Quinn has signed Public Act 96-1421, which amends the Illinois Interest Act to expressly permit use of the "365/360" method of calculating interest on commercial loans.
Leading up to this development, a flurry of class action lawsuits against financial institutions have called into question the legality of the well-established interest computation method, which has been routinely used by commercial lenders "since time immemorial," according to one Cook County Circuit Court judge. Plaintiffs throughout the state have asserted that commercial promissory notes violate Illinois usury law when they specify that interest will be calculated according to a 360-day year and the actual number of days elapsed (i.e., 365). This claim is rooted in the Illinois Interest Act, which stipulates that interest must be calculated based on a year comprised of 12 calendar months (i.e., 365 days) whenever a promissory note specifies a "per annum" or "per year" interest rate—as virtually all commercial promissory notes do. Plaintiffs have also claimed that using the "365/360" method constitutes common law fraud and violates the Illinois Consumer Fraud Act. Making matters worse for lenders, defendants in mortgage foreclosure cases—lacking any other way to extricate themselves from failing business deals and save their properties—have raised the illegality of the interest calculation method as an affirmative defense.
The economic underpinning of the borrowers' claims is that use of the "365/360" method results in a higher effective interest rate than the rate stated on the note. For example, if a promissory note establishes the interest rate at 5% per annum, with interest calculated according to a 360-day year and the actual number of days elapsed, then the effective interest rate will be 5.069444%, or 5% x (365/360). That means a borrower will pay an extra $694.44 a year in interest on a $1 million note. While trial court judges in Cook County have sided with the lenders in recent decisions, one downstate class action case resulted in a substantial settlement in favor of the plaintiffs.
Understandably, this rash of litigation put fear in the hearts of commercial lenders throughout Illinois and galvanized the industry to lobby for legislation. The result was Public Act 96-1421, which became law in August 2010 and amended the Illinois Interest Act to provide that "a rate of interest may be lawfully computed when applying the ratio of the annual interest rate over a year based on 360 days." The act further states that the provisions of the amendment "are declarative of existing law." Interestingly, however, the sponsor of the bill in the Illinois state senate remarked for the record that the "legislation will not dictate the outcome of any pending [litigation]. That will be up to the individual courts to apply the law."
While it may be back to business as usual—at least with respect to calculating interest for commercial loans—lenders should take careful note that Public Act 96-1421 only applies to commercial loans and is silent with respect to consumer and residential mortgage loans. Lenders should also consider certain precautions to minimize the risk of future litigation. In addition to clearly setting forth in the loan documents that interest will be calculated on a "365/360" basis, lenders should require borrowers to acknowledge that use of this method will result in an effective interest rate that is higher than the stated interest rate.