1.2 Calculating interest: SOFR, day counts and interest periods

Every quarter, the agent tells each lender how much interest the borrower owes, and each lender's operations team checks the number. Most breaks between what was expected and what arrived come down to three inputs: the rate, the number of days, and the day count convention.

This lesson takes the Alder Ridge Logistics loan from PC101 3.3 and calculates one interest payment the way an operations team would, then shows how each input can change the answer.

The rate: base rate, floor and spread

As PC101 3.2 explained, a floating-rate private loan pays a base rate plus a spread.

In US loans the base rate is SOFR, the Secured Overnight Financing Rate. SOFR itself is an overnight rate, so loans use it in one of two ways:

• Term SOFR is a forward-looking rate for a set period, such as one, three or six months, published at the start of the period. The rate is known in advance, like the old LIBOR. It's commonly used in US loans.
• Daily SOFR uses the overnight rate for each day of the period, either simple or compounded, so the total isn't known until the end. Some loans use it.

The rest of this lesson uses Term SOFR.

If the loan has a floor, the base rate used is the higher of SOFR and the floor. The spread is then added on top.

The interest period

A loan's life is divided into interest periods. At the start of each, the rate is set; at the end, interest for the period is paid.

• Length: the credit agreement commonly lets the borrower choose among set lengths, such as one or three months.
• Rate setting: the Term SOFR fixing is commonly taken a few business days before the period starts, so everyone knows the rate in advance.
• Business days: if a period would end on a weekend or holiday, the agreement's business day convention moves it, commonly to the next business day. That changes the number of days, and so the interest.

The agent sends a rate notice at the start of each period showing the rate that applies, and a payment notice before the end showing the amount due.

The day count

A day count convention says how to turn an annual rate into interest for a period of a given number of days.

• Actual/360: actual days in the period ÷ 360. US loans commonly use this for SOFR-based interest.
• Actual/365: actual days ÷ 365. Used in some markets and for some other products.

Because Actual/360 divides by 360 while a year has 365 (or 366) days, a full year's interest comes to slightly more than the quoted rate. At 9.25%, a 365-day year earns 9.25% × 365 ÷ 360 ≈ 9.378%.

Worked example: one quarter's interest

The following example is illustrative. Alder Ridge's $100m loan pays Term SOFR + 525 bps with a 1.00% floor. For the next interest period:

Interest = principal × rate × days ÷ 360

= $100,000,000 × 9.25% × 91 ÷ 360

= $2,338,194.44

That's the amount on the agent's payment notice, before the agent splits it among the lenders (lesson 1.1).

How each input changes the answer

The day count alone moves the payment by $32,030.06 on one quarter of one loan. That's why a mismatch between the agent's convention and the one set up in a fund's loan system is a classic source of cash breaks (lesson 4.1).

In the floor case, SOFR at 0.60% is below the 1.00% floor, so the rate is 1.00% + 5.25% = 6.25%. Without the floor it would have been 5.85%.

Other things that change the interest

• Principal changes during the period. If part of the loan is repaid or a delayed-draw tranche is funded mid-period, interest is calculated on each amount for the days it was outstanding. The agent's notice shows the breakdown.
• Several interest periods at once. A borrower may have different pieces of a loan on different interest periods, each with its own rate. Each piece is calculated separately.
• Default interest. After an event of default, credit agreements commonly allow an additional margin, often 2% a year, on overdue amounts or on the loan while the default continues.
• Fees. Commitment fees on undrawn amounts (PC101 3.2) are calculated the same way, on the undrawn balance and the agreed day count.

For operations teams, the rule is simple: set up each loan with exactly the conventions in its credit agreement, and recalculate every notice independently.

Key terms

• SOFR (Secured Overnight Financing Rate): The US dollar base rate for floating-rate loans.
• Term SOFR: A forward-looking SOFR rate for a set period, known at the start of the period.
• Interest period: The span of time for which one rate applies, with interest paid at the end.
• Day count convention: The rule for turning an annual rate into interest for a number of days, such as Actual/360.
• Rate notice: The agent's notice of the rate that applies for an interest period.
• Default interest: An extra margin charged while an event of default continues.

Key takeaways

• Interest = principal × all-in rate × days ÷ the day count basis.
• The all-in rate is the higher of SOFR and any floor, plus the spread.
• US SOFR loans commonly use Term SOFR and Actual/360, so a full year earns a little more than the quoted rate.
• Wrong day counts, missed floors and mid-period principal changes are common causes of mismatched interest.
• Recalculate every agent notice independently, using the credit agreement's conventions.