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feel uneasy when the two rates are distinct, unwarranted by the way, there are other consequences influenced by this outdated and erroneous mind-set.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

Why One Size Doesn't Fit All

Fighting the conception/perception that the credit industry is operated and regulated on a standardized basis and that parameters are of the “one size fits all” variety isn’t easy.

We constantly work with a variety of prospective clients in the credit industry to explain that choices on a wide variety of fronts and levels are available to lenders when it comes to compliance.

It’s a nice thought that we can just “simplify” things and still meet the specific business and regulatory requirements of our clients.

The reality is that compliance parameters don’t always contain clear cut universal mandates.

To illustrate this point, let’s review the perceived simplicity of credit insurance prima facie rates and state regulated maximum interest charges.

Prime Facie Credit Insurance Rates

It is an accurate description that published prima facie rates are insurance rates that may be used “without providing further justification”, but that doesn’t mean every lender provides credit insurance at those particular rates.

Deviations of prima facie rates based on the actual experience data provided to a state insurance department and their actuaries are often mandated by state insurance codes.

 Simplistically put, if you brought in a lot of premium revenue over the last three years but paid virtually no claims, there’s a good chance the Insurance Department will adjust a lenders rates downward to meet previously determined standards in that regard.

 Conversely, if your claims costs exceed the premium revenue for a stated period, the Department may allow an upward deviation from the prima facie rate as a form of recompense.

We have seen a lot of programs with a nationwide dealer base writing credit insurance in all 50 states make the decision to initially employ the prima facie rates for all their dealers with the goal of “facilitating” the roll out process.

While it’s true that as many as 80% of the dealers may use prima facie rates, the 20% that don’t sure create an administrative headache for the service provider when they are forced to retro-fit all the rates and underwriting limits for those dealers.

The timing is usually so that as the program is just gaining some steam and traction, resources have to be diverted from growth to the re-tooling process.

State Regulated Maximum Interest/Finance Charges

How much interest or finance charge a lender can produce on a credit contract is one of the most misunderstood regulatory disciplines in the industry.

Since most state maximum charge statutory provisions actually regulate the dollar charge generated by a published rate, Carleton’s compliance generator will evaluate the total dollar charge in a transaction against that computed according to statutory/regulatory rules.

However, in order to perform that task we first have to determine which specific provision a particular lender is operating within. Sounds simple enough, doesn’t it?

However, take the state of Texas for example. An institution making a consumer loan under the Texas Finance Code cannot produce an interest charge that will exceed:

A) The dollar charge produced by a split add-on rate structure with rates of 18% and 8%.

Or

B) The dollar charge produced by a melded simple interest structure with rates of 30%, 24%, and 18%, respectively.

Or

C) The dollar charge produced by the alternate simple interest rate tied to Treasury Bill auctions with a provision that contains a ceiling rate and a floor rate.

All of the above qualify as “maximum rate provisions” under the Finance Code.

All can produce significant and varied results when inserted as “THE” maximum charge standard to evaluate an actual loan against.

So, if an “out of the box” solution is presented, which set of rates to choose?

That is a truly key point: everywhere in the compliance process, the lender has choices available.

Don’t Forget the Lender

It is almost impossible to be in sync with a specific lending institution without a discussion that sheds some light on their philosophy and policies. Is their compliance philosophy conservative? aggressive? moderate?

In the end, it is what the institution views as the applicable maximum charge provision that is relevant.

We counsel our clients based on experience but the final call belongs to the lender. Trying to work outside that sphere of knowledge one can only harbor a guess at the “right” answer.

When it comes to compliance, I’d rather not guess.

The “one size fits all” approach does seem to mirror the current trend in our society for all actions to be “seamless” and “transparent”.

 However, it is important to recognize when it comes to calculations and disclosures that the desired transparency is not necessarily a synonym for “easy and fast” but one that adheres to clear and accurate validation of where those values/numbers came from and the basis for their accuracy.

The Rule of 78ths

What's in a name?  Often through this blog, and other writings over the years, you have heard me preach clear communication.  The use, and mis-use, of labels, slang, jargon and other esoteric terms not only makes it difficult to communicate in this industry, it can also lead to less than stellar compliance performance when it comes to calculations and disclosures.

Almost everyone in the industry is familiar with the term "Rule of 78ths".  Ever think about how much you really know about this widely used term?

Here are some things that I know after 27  years of dealing with it:


1) It's an allocation method not a "calculation" method.  I can compute monthly payments that will adhere to a Rule of 78ths allocation of the charge and liquidation of the principal, but I cannot "compute a payment by the Rule of 78ths".

In the heyday of add-on and discount interest, the need arose for a way to determine how much interest was to be allocated to a specific period of time.  Both add-on and discount compute interest charges based on the life of the loan and there is no thought to repayment terms.

Creditors needed a way to determine "earned" interest and, thus, "unearned" interest.  This is how the method grew into a popular method for computing refunds when a loan is prepaid in full before maturity.  It was easy and uncomplicated.

2) It's technically only the "Rule of 78" for a 12 month transaction with equal monthly payments.  The "78" refers to the sum of the numbers 1 through 12.  Since the use of Rule of 78ths requires the summing of the number of payments remaining divided by the sum of the original number of payments, the 78 portion is only applicable if there are 12 payments in the loan.

3) The more precise name is "Direct Ratio" method.  Direct Ratio assumes that the portion of the total charge contained in each installment is computed as a direct ratio of the number of remaining unpaid installments to the sum of the original number of installments.

I wish I could claim that I crafted that definition myself but I can't.  It comes from one of the rare textbooks that address lending calculations titled "Neifeld's Guide to Instalment Computations" by Dr. M.R. Neifeld.  It was first published in 1951.  This definition forms the premise of the concept for which we all take the mathematical shortcut of summing remaining and original payments to find the valued "factor".

4) Most statutes authorize The Sum of the Balances method in the language they use to describe refunds of interest and charge.  The statutory language talks about the sum of the "monthly time balances" scheduled for a loan not the number of scheduled payments.  That provides a more accurate description of the Sum of the Balances method, of which Rule of 78ths is a subset, which accounts more properly for irregularities.

5) The Rule of 78ths can provide accurate computations only if there are none of these irregularities in the loan transaction.  Loan characteristics such as balloon payments, irregular payment amounts, irregular first intervals (aka "45 days to the 1st Payment), skipped payments, non-monthly repayment periods (e.g. quarterly payments) etc. render  a Rule of 78ths calculation imprecise mathematically at best.  The simplistic, traditional Rule of 78ths shortcut cannot properly account for the actual balances and the time they are scheduled to be outstanding.

But when is the last time you had a generic, simple loan transaction with no type of irregularity?  Those transactions seem to be few and far between these days.

6) While Rule of 78ths is  more often used for interest or charge refunds, it can also be used in the proper setting for determining unearned credit insurance premium or ancillary product charges.  The same rules for irregularities, however, continue to apply.

Like a lot things in an ever evolving industry, the intent of "Rule of 78ths" was most likely the concept of the more robust Sum of the Balances method.  As loan products become more complex, the methods we apply to specific operations must adjust also.

Rule of 78ths is still in use today on a regular basis.  However, it is not a "one size fits all" solution and the characteristics of the loan itself determine it's accuracy and viability.

Navigating the Pendulum Swing

What do the following have in common? HMDA, Fair Lending, Suitability, Arbitration, CRA, Ability to Repay, Interchange Fees, Credit Freeze, Risk Retention, Appraiser Independence, FCRA, ECOA.  The answer is,  they all have been regulatory and compliance hot topics in the last 60 months or so.

They are all evidence of the ever-changing regulatory environment that lenders face in the current climate.  However, one facet that these topics don't represent is also significant: they aren't directly computationally  oriented. At the moment, the regulatory pendulum is swinging markedly away from calculation type issues.

Yes, we had the Reg. Z MDIA mortgage disclosures at the beginning of 2011 that did have some direct impact on loan disclosures and calculations.  It certainly made all of us contemplate combinations of potential loans that we didn't even know existed.  But we seem to have survived that window of activity and we'll see what kind of feedback regulators receive once those disclosures have been in use for a year or so.

But when you look at that laundry list of regulatory initiatives, it is clear that direct calculation issues are on the back burner, barely keeping lukewarm.  That merits the question of whether that is by design, or have all the other issues simply pushed them into the background where they can't be seen clearly.

Understand, I'm not championing a new era of calculation-driven regulation, even though I think that's in the back of everyone's mind waiting on the CFPB.   Besides new calculations that could potentially arise during upcoming rule making, there also needs to be a focus on explaining existing calculations.  Remember the mandate from Dodd Frank for plain language, simplicity, and transparency.

There are times it makes me a bit nervous that perhaps inaccuracies and imprecision are being overlooked because of the concentration on other administrative type subjects and issues.

The worst nightmare is a frenzied tweet from the compliance staff, "OMG you should have seen what the examiner just cited us for," and to find out that practice/calculation /disclosure has been in place since 2003.  It's just been obscured and overlooked because of the focus on compiling tons and tons of database information for various governmental agencies.

Don't get caught off guard.  Sure part of this concern is my general paranoid nature, especially when things seem to be running incredibly smoothly, but I think it's essential that internal controls focus on all aspects of compliance and not just the ones with steam rising off the top.  Make no mistake, the pendulum will swing back the other way at some point. Be prepared.