Is It Really a 360 Day Year?

Whenever, in the discussion of consumer credit calculations, I hear someone say "Well, that's a 360 day year,"  I ask myself "Is it really?" and "Why would you want to craft your disclosure calculations to conform to that in the 21^st century".  The concept of the "360 day year" is a bit like the energizer bunny:  No matter its age, it goes...and it goes...and...  well, you get the idea.
 
In this day and age when your cell phone most likely has more processing power, memory and storage than most mainframe computers of 35 years ago, why would anyone want to build a system that ties the compliance of their calculations with a method that, in its purest form, creates an artificial 29th and 30th of February most years?

I think one component of this frame of mind is the erroneous belief that Appendix J of Regulation Z "prescribes a 360 day year" to properly compute an APR. Not so. The language in Appendix J merely states that "All months shall be considered equal". There are no instructions to skip the 31st of a month when it happens or to create two days in February.

This would appear to be a danger zone for many origination calculations in light of the CFPB's professed intent to ensure front end origination calculations conform to, and are consistent with, the back end servicing/processing calculations.  The practical implication of servicing the artificial machinations of the “360 day year” is quite significant.

If that's the case, consumers will get an interest accrual holiday during servicing seven times a year and pay interest for two non-existent days each February. Does this really seem like the core of a sound cutting edge compliance program?

 

More on Truth in Lending APR Disclosures

It's pretty obvious that the subject of interest rates versus APR's just isn't going away. The topic arises daily in our customer service area with questions from clients and users of our software. The more we deal with it, the more we realize it is actually a multifaceted issue.

 The expectation of the Truth in Lending Act APR being the same value as the computational interest rate when no fees are included is simply a by-product of an earlier era when limited computer power led nearly every system to use a "360 day year".


The concept of "simple interest" transactions where interest accrues on a daily basis completely changes the landscape. The key point here is that the TILA APR is a computed value.


Think about it this way; Appendix J of Regulation Z contains 16 pages of definitions, variables, and algorithms to show lenders how to properly compute the APR. Why is that if the APR is merely a regurgitation of the interest rate?  Doesn't really make sense, does it? The APR is designed to "level the playing field" and compute a standardized rate of return regardless of how the lender accrues interest charges.
 

If your system APR calculation routine needs to know how you computed your payments, you’ve got a problem on your hands.  You don’t’ need to know the interest rate; for that matter, you don’t even need an interest rate.  Many of the state regulated small loan alternative rate structure allow charging a stated handling charge per month of the contract.  The lender still has to compute and disclose an accurate APR.


But beside the fact that lenders often feel uneasy when the two rates are distinct, unwarranted by the way, there are other consequences influenced by this outdated and erroneous mind-set.
 

Over time business practices are put into place based on the false premise that the interest and APR “are the same”. Two of the most glaring suspects are exporting the TILA APR into the core servicing system and routinely advertising and quoting "APR" on credit transactions when the value published/quoted is actually the interest rate.
 

If the TILA APR is accurately disclosed as 10.02%, pulling that rate into the servicing system will accrue interest at that rate rather than the interest rate of 10%.  Depending upon the specific contractual obligation in effect, the borrower may pay more interest over the life of the loan than originally agreed to.  If the lender is operating at a state regulatory maximum rate, that can also lead to potential usury concerns.


The advertising of rate, especially in the retail arena, can be quite competitive.  A practice established in the days when both interest and APR calculations were based on months and a nominal 10% disclosed as “APR”, can lead to potential violations when the accurately computed APR is 10.02%.

U.S. Rule vs Actuarial Method APR Disclosure

While the subject has been around now for over 30 years, it's still a question we get asked a lot: should I use the actuarial or U.S. Rule method to compute and disclose the A.P.R.?

Like any sound decision when making choices, it is important to understand the properties of each method involved and the context from which the decision is based.

Regulation Z allows a compliant and accurate Truth in Lending Act A.P.R. disclosure by either method.  The regular 1/8 of 1% tolerance may be measured from the properly computed number computed by either method.  So, at first glance, it may seem like a simple and obvious choice to make but there are some practical considerations to take into account.

First, Appendix J of Regulation Z lays out precise definitions and variables for a basic effective rate of return iterative routine...........for the actuarial method only.  The United States Rule is an accounting/allocation concept that cannot be accurately portrayed by a linear "formula" for all potential eventualities.  It is essential to understand the U.S. Rule concept in depth to build a computing routine that will always produce an accurate APR value.

Second, for that very reason the vast majority of regulators and auditors use the OCC program APRWIN for Truth in Lending APR validation.  It is important for creditors to recognize that the tool that is nearly always employed only utilizes one of the two authorized methods of APR computation.

If you are a creditor that incorporates what are often referred to as 'transactional irregularities", e.g. 90 days no interest, no payment, in your financing plans, the goal is generally for the APR to be as close to the input interest rate as possible.  The interest charge is undoubtedly computed by the U.S. Rule method, to avoid inherent compounding of interest, so only a U.S. Rule APR will meet that objective.

But from a practical standpoint, your regulator is going to walk in with APRWIN on his/her laptop every two years and the ensuing process will undoubtedly require a fair amount of explanation and education to avoid a citation for a material TILA violation.

Yes, the Fed complicated the matter greatly during Truth in Lending's "simplification" process some thirty years ago by allowing a second computation method, not to mention diminishing the idea that the APR would be a single barometer to level the playing field for intelligent consumer credit decisioning. But that is reality and we counsel creditors on a regular basis about which APR disclosure best fits their goals and objectives.

It's All in the Payment - Part II

We've been away for a while without a new blog post waiting for the launch of the new Carleton, Inc. website which will be the new home of the Carleton Compliance Blog.  Like any undertaking of that magnitude, it is taking a bit longer than originally planned but we're almost there.

 Meanwhile, subjects, issues, and opinions have been piling up, so it' time to get back on track talking about consumer credit calculation compliance.

In May of this year we discussed how all the components of a credit transaction are included in the computed payment amount.  You just have to know which perspective to view things from to see them.

Now, rather than look at components included in the payment amount, we want to examine the nominal payment amount itself.  One characteristic of simple interest (aka "interest bearing", "per diem", "daily interest") consumer credit transactions is that the regularly scheduled payment amount is often viewed as rather arbitrary in nature. 

Since there is a good chance the consumer will not make each and every payment exactly on the scheduled due date, even though electronic debit technology is starting to challenge that thought, the actual interest accrual and outstanding principal balance profile will not match the scheduled amounts anyway.  So, the computed/disclosed regular payment amount is arbitrary in nature and the final payment amount will reflect it along with the potentially nebulous paying habits of the consumer.

Well, there is a dose of truth and reality in that thought.  However, from the perspective of  a service provider whose point of concentration is the computed disclosures, we realize that you can't logically program "arbitrary".

By that, we mean the regular payment amount has to be based on some criteria.  We choose to do the following in our computing routines:

• The regular payment amount is the full  precision amortizing payment for the balance and rate computed on the assumption that all payments are made and posted on scheduled payment dates.  If you took that full precision payment and posted payments on the schedule due dates, the final balance would be zero at maturity.
• The regular payment is then high rounded to ensure the computed odd final payment will not exceed the amount of the regular payment.
• The process of "high penny rounding" the payment also minimizes the difference between he regular payment and the computed odd final payment.

Twenty years ago the code to  find an actual day interest, simple interest payment was cumbersome and slow.  Today's increased computing power and processing speeds have made those past concerns and constraints a moot point.  However, we still regularly encounter systems that take a formula approach to computing the regular payment.

Since there is no precise formulaic solution to computing a payment accruing interest on an actual calendar day basis, these approaches produce payment amounts that are not precisely the amortizing payment amount. The only accurate way to arrive at the accurate amortizing payment is through the process of amortization.

Sometimes, the difference between the amortizing payment and the formula payment is slight, say two to three cents, and sometimes it is more significant, somewhere in the neighborhood of eight to twelve cents.  However,  the effect of even the larger difference can be mitigated by the process to arrive at the remaining disclosure numbers.

By that I mean as long as the regular payment amount is set and an accurate process of amortization on an actual day calendar basis interest accrual is used to arrive at final last payment, the results are accurate and compliant.  The amortization process to arrive at the final payment ensures that the effective contract rate is maintained.

For example, $9,000.00 principal, 12% simple interest, 60 payments
Date of Contract 08/15/12
Date of 1st Pmt  09/15/12

A - Amortizing Payment
Accurate amortizing payment: $200.188749 or $200.19
Final payment amount: $200.05

B- Formula Payment
Formula payment: $200.27
Final payment: $193.63

When actual calendar days accrue interest and the rate for each day is 1/365 in a  normal year and 1/366 in a leap year, both transactions amortize to a zero balance at scheduled maturity.

Example A produces $1.70 more in total interest charge.  The larger payment in the formula approach liquidates the principal just a bit faster and, thus, produces slightly less of a charge.

The key here is that both payment schedules amortize the debt to a  zero balance at maturity and maintain the effective interest rate of 12% simple interest.

With "simple interest" (aka interest bearing) loans it is difficult to make a case for a 'right payment' amount.  Unlike precomputed loans where the interest each period is pre-determined, the simple interest approach lends itself to potential fluctuations from scheduled amounts based on the paying history of the borrower.

Carleton would employ method A as a default.  We like to be able to explain exactly how the payment we disclose was crafted and what rules were employed during the calculation.  We believe that's part of accurately portraying the contractual obligation.

Consumer credit mathematical routines are so complex that one significant drawback to a "formula" approach is that it is open to the interpretation of the creator.  Many choices and decisions are made while employing the formula and chances are very good that only the original developer/programmer who created it knows what those specific points are.  So duplication is often an issue if the creator isn't around to be involved in later retro-fitting.

This is an instance where the payment amounts for the two approaches do not need to be identical for the transaction disclosures to be accurate, valid, and compliant.  The path to the destination may take different routes, but the end result is the same.

It’s Leap Day – Do your lending calculations handle leap year?

Happy belated 2012 to all our blog readers!

We’ve taken a bit of a break from the blog to tend to some end of the year housekeeping chores, but we’re back on track and looking forward to a host of new discussions on the computational aspect of lending.

It’s leap day, February 29^th.  While leap day, and leap year, is ostensibly a corrective calendar measure, attributed most often to Julius Caesar,  I am always intrigued when it rolls around every fourth year as to what effect it may, or may not, have on lending and servicing systems.  It makes me wish I could travel in an Ebeneezer Scroogesque manner and see first- hand what happens inside every lending institution in America on this day.

• If a payment is received and posted today is it recognized as 2/29/2012? 
• Does interest accrue on the balance at 1/366 of the annual interest rate? Or 1/365?
• If your front end originated the payment on an “exact day” interest basis but uses a “365/365” calendar, does that mean you skip today when posting?  Or post as of February 28^th so as to be fair to the consumer? Is the system possibly collecting one more day of interest than was agreed to contractually?

I have a basket load of permutations and combinations of those types of questions that always intrigue me regarding leap year.  My largest wonder is whether it’s all simply academic or does leap year indeed directly impact the nuts and bolts operations in the creation and collection of loan payments.