In Part 1 of this Thought Leadership series on simple interest, Carleton discussed how simple interest transactions have complicated previously held beliefs about consumer credit computations. While periodic interest calculations may closely align and appear identical to actuarial method APR computations, simple interest calculations do not always follow suit.

By measuring actual days elapsed and not simply counting a month as 1/12 of a year, simple interest added a layer of complexity to what was previously considered “easy” math.

Part 2 addresses another complication brought about by the use of simple interest—the fact that there can be multiple “right” payments.

Simple interest’s biggest impact can be seen when prospective interest charges accrue on the actual calendar days elapsed between scheduled payment dates. This is a departure from the historical “periodic” interest charges that accompanied precomputed transactions. For the purpose of interest accrual, periodic interest considers all months equal and interest accrues at 1/12 the stated annual interest rate. Periodic interest does not recognize that months have differing numbers of days.

Why is that important? Because merely looking at the stated interest rate leaves a skewed picture. The rate is merely one component of the process. The application of the rate to accrue interest is often the overlooked key parameter. Simply put, this is the reason we see such confusion in the credit industry when the contract interest rate and Truth in Lending Act (“TILA”) annual percentage rate (“APR”) are not the same value.

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Key Considerations Regarding Simple Interest

1. There are different methods of accrual calendars and the month in which the loan originates
2. When accounting for a maximum charge on a loan, loan data must be evaluated when using applicable parameters identified in statutes

Urban Myths

Part 1 addressed the first urban myth that: “If there are no fees included in the finance charge, the interest rate and APR are the same.”

Urban Myth #2: There is only one “right” payment for a set of data

With simple interest, a set of data could potentially have a dozen different amortizing payments depending on the month in which it was originated. The amount of interest calculated on using a daily accrual method is dependent upon the month of origination and the number of days of interest which accrue early in the transaction. For that reason, the exact same set of data will accrue less interest on a deal beginning in February (28 days) than one that begins in March (31 days). If there are more days accruing interest at the beginning of a loan when the balances are at their highest, the entire profile of prospective interest accrual changes. So too does the comparison between the applied interest rate and the APR when utilizing a periodic calendar vs. a daily accrual calendar.

Carleton has seen at least 13 different payment accrual calendars, all utilizing different combinations of time counting, including for example: periodic or daily accrual, counting 365 days a year or 366 days a year on leap year, or counting whole months and days. Based on these different methods of accrual calendars and the month in which the loan originates, there can be varying effects on the applicable amortizing payment and interest calculations.

Urban Myth #3: A State’s maximum rate provision is simply a nominal rate comparison. The method of charge accrual is irrelevant

So how do regulators view the industry shift towards simple interest? Many jurisdictions’ statutes written in the 1970’s and 1980’s state that for the purposes of computing the maximum finance/credit service charge “the differences in the lengths of months are disregarded.” That would imply that a periodic calendar is to be used when determining if there is an overcharge.  The key point here is that a majority of state statutes regulate the dollar charge contracted for by the creditor.  So, the application of the published maximum rate becomes a crucial data point.

Even when a statute employs language that makes the maximum rate synonymous with the TILA Appendix J APR value, Appendix J allows a compliant APR to be computed by both the actuarial and U.S. Rule methods.  Often, the methods return identical results, but just as often they provide distinct APR values.  So, which one is “right”?

This notion can be illustrated when the consequences of applying a daily interest rate of 18% results in a TILA APR of 18.03% (which uses the periodic calendar). That means that if the differences in the lengths of months are disregarded, the effective interest rate is 18.03%. But when a daily calendar is used, the effective interest rate is 18%. Using the effective interest rate of 18.03% technically results in a violation of the maximum charge provisions in the statute. This violation is a result of a daily calendar used to accrue interest charges and another mandated to assess the result. If an actuarial method APR is disclosed, the APR box itself may be evidence of an overcharge.

Of course, a creditor can compute and disclose an APR by the United States Rule method and employ daily charge accrual. In that situation, the interest method and APR method are identical resulting in an APR which will match the interest rate.

One practical consideration that needs to be made by disclosing parties is that nearly every examiner in the United States carries a free download of the OCC’s APRWIN Software Program on their laptop. APRWIN is a credible tool, but it only computes by the actuarial method APR and cannot validate a U.S. Rule value. A creditor needs to be able to strongly justify and prove their APR disclosures at every examination—it’s a fact that most don’t have the proper tools to do so.

One final operational effect of the movement from the precomputed environment is the difficulty of porting a TILA APR into a servicing system to accrue actual interest earnings and service the loan. One of the main features of a precomputed contract is that the consumer is agreeing to repay a total of payments and that is synonymous with the rate found in the APR. When the APR and contract interest rate were interchangeable—during the era of precomputed contracts—the practice of porting an APR into the service system was widespread. Now, when utilizing daily simple interest the resulting APR for an 18% contract interest rate may be anywhere from 17.97% to 18.04%.

Thus, when accounting for a maximum charge on a loan, the loan data must be evaluated when using the applicable parameters identified in the statute.

Keeping it Simple: Resources for Compliance

Carleton’s products and services are synonymous with consumer credit calculation compliance since 1969. Priority is given to maintain its position as the industry’s leading authority with respect to loan calculation accuracy.

Carleton clients receive compliance support from Carleton’s Compliance team in three critical areas: constant monitoring for change in regulations through state and federal databases, continual testing and implementation of new quality control methods to ensure software calculation accuracy, and litigation support providing backup in any client legal support needs, including:

• State & Federal Law Database – Carleton’s Compliance Department maintains a regulatory library and constantly monitors changes in state and federal regulations related to loan calculations. Carleton is also able to remain at the forefront of breaking legislative developments through a myriad of subscription services related to lending, professional legal relationships, active participation on law committees of national lending associations, and the compliance departments of many of the major lenders who are clients of Carleton.
• Verification of Calculations – Our Compliance Department is involved in designing programs to test the accuracy of all Carleton calculations and ensures that an updated quality control program is in place to support the changes in regulatory compliance for all state and federal regulations.
• Litigation Support – As part of Carleton’s maintenance and customer support, the Compliance Department is available as a resource to assist clients in providing the basis of the computations and validation of the calculation accuracy in the event a state or federal examination results in a requirement to defend or explain our company’s loan computations.

Carleton, Inc. also provides a range of Compliance Support Services, including:

• TILA Reimbursement & Adjustment Calculations
• Recasting of loans
• Creating amortization Schedules to “prove” a lending transaction
• Examination support through providing dollar and cent illustrations
• Analysis of client’s internal system calculation requirements

Carleton, Inc. is the leading provider of compliant lending and leasing calculation software and dynamic document generation software serving the banking, credit union, and auto lending industry.  Founded on compliance expertise at a federal and state level in 1969, the company’s client list has grown to include most of the major lenders, credit insurance companies, and loan origination software providers in the United States.

Jean-Baptiste Alphonse Kerr famously wrote, “plus ça change, plus c’est la même chose” — the more things change, the more they stay the same.  This statement is applicable in many situations, but in our world if you attend any consumer finance conference, you can count on at least one or frequently more of the general sessions primarily dedicated to discussing FinTech, Marketplace Lending, Online lending or whatever moniker you may want to describe the emerging trend of extending credit without having a brick and mortar physical presence.

Regardless of the medium or vehicle for the transference of data, there is one essential property to every credit transaction that never changes, “the numbers.”  The numbers are the essential property that forms credit disclosures and serves as the fundamental ingredients of the contractual obligation between a lender and borrower.  The “calculations” are the common denominator inherent in every single credit transaction across all types of lending and all credit markets.

The incredibly complex and esoteric nature of the consumer credit math that produces the disclosure numbers is often an enigma to the participants of FinTech lending.  FinTech principle players generally have strong IT backgrounds and access to investors willing to provide funding, but, more often than not, lack the consumer finance calculation background and experience.  The common mantra for consumer lending calculations is that they are “just math”.  However, that “math” is the crucial element for whether those ever present disclosure numbers will be deemed in or out of compliance by auditors and examiners.

The regulatory landscape for FinTech at the moment is anything but clear when you consider the results of litigation putting the “Bank Partnership Model” in jeopardy due to the Madden v. Midland ruling.

Until the valid when made doctrine is either expressly upheld or rejected, the regulatory framework for FinTech sits in limbo to a great extent and the only completely safe model appears to be that of becoming a licensed lender in the individual states in which business is transacted.  With an internet-based lending model, that most likely means a license in all 50 states.

Regardless of the lending model framework, FinTech or traditional Brick and Mortar segment of the market, Carleton’s core experience and expertise is in supplying the compliant credit math component no matter how complex or simplistic the requirement.  In today’s industry, with the cacophony of ever increasing regulatory requirements, why take on the burden of creating and maintaining The Common Denominator… The Math…

At Carleton, we spend a lot of time and focus on helping our partner lenders stay compliant in the area of the maximum state finance charge that is allowed by a statute or regulation.  Consistent with our expertise, once we drill down to the granular detail, the compliant calculations are not always what they seem.

Regarding the financial term usury, in our opinion usury is not always the most technically correct term for statutory maximum charges, it is however the financial term used most frequently in the industry.  The usury calculation focus by most lenders is almost always on the rate itself.  We have frequent discussions that usury is not merely the rate itself but the application of that published maximum rate that is integral to being compliant.

The passage of HB 1511 in Mississippi recently is a perfect example.  The new Consumer Alternative Installment Loan Act prescribes a maximum rate of 59%.  There is also a provision making an allowance for a daily interest accrual calendar, aka 365/365, that recognizes the current trend toward “simple interest” interest-bearing loans and away from traditional pre-computed transactions.

However, like other provisions in the Mississippi Code, it is clear that the maximum 59% will be measured by the “actuarial method”.  Since that label is defined in the small loan regulations as holding the same meaning as in Regulation Z that implements the Federal Truth in Lending Act, which means the 59% will be a TILA APR type number.  The actuarial method requires the “Federal Calendar,” which is a monthly accrual calendar and recognizes each month as 1/12 of a year.

The effect is what we see frequently in today’s consumer finance industry.  Applying a nominal contract rate on a daily basis yields a different value when it is measured on a monthly basis.  In the case of the Mississippi bill, applying a 59% contract rate using a 365/365 calendar can yield an actuarial method APR as high as 59.18%.

That means lenders will have to reduce their in-going contract rate in order not to violate the 59% maximum provision.  That fact is not evident unless you live in the “weeds” of the consumer finance mathematics as we do at Carleton.  In most states, it is the state “finance charge” as a dollar amount that is regulated and not merely the published nominal rate.  That is one reason “table lookup” is not always a safe and efficient method of testing for compliance.

Carleton announces the July release of the latest CarletonCalcs® Origination module to support the changes identified in the 2015 amendment of the Military Lending Act (MLA) effective October 3, 2016. Previously, the regulation was limited to payday, vehicle title, and refund anticipation loans, but as of October 3, 2016 will affect nearly all lenders extending credit to active military personnel.   The purchase of motor vehicles and 1^st lien purchase mortgages have been excluded.

Credit insurance and fees for debt cancellation or debt suspension fees are included in the calculation of the MAPR in accordance with the John Warner National Defense Act in 2007.  The major change from the DOD to the new regulation is that “bona fide” fees may now be excluded from the MAPR.  The Act defines interest for the purposes of complying to include:

• Application fees* (new requirement)
• Points, origination fees, participation fees – all fees in the TILA finance charge
• Single premium credit insurance premiums
• Single amount debt protection charges/fees (cancellation and suspension)
• Any credit-related ancillary product sold in conjunction with the transaction

The Military APR cannot exceed 36%.

Carleton has added the ability to the CarletonCalcs® Origination module to customize which fees will be included or excluded to allow lenders to customize which fee will affect the MAPR to meet their individual needs.

If you have any questions regarding this release and how Carleton can help you stay compliant with the MLA, contact your Carleton sales or support representatives at (800)433-0090.

An industry trend of the steadily increasing pace of regulation and the resulting volume of requirements is placing a great deal of pressure on an already stressed “creditor” compliance management systems.  Since the Consumer Financial Protection Bureau does not have direct jurisdiction over auto dealers, the CFPB have aggressively pursued and scrutinized indirect auto lenders and creditors in a number of calculational and compliance capacities.

This increased scrutiny on the indirect lending institutions intensifies the need for ensuring that assigned portfolios of motor vehicle sales transactions are “squeaky clean” from a compliant calculational and disclosure perspective.  This presents a unique challenge for many creditors that inherit/purchase bulk transactions that have been originated on a wide spectrum of systems with varying degrees of complexity and sophistication.  As a result, at Carleton, we have noticed that many major purchasing decisions for bulk portfolio purchases have in part depended on the “cleanliness” of the loans.

As the indirect lending industry itself adapts to meet consumer needs, the industry has drifted from the traditional equal payment “regular” transactions to more “exotic” transactional features being offered.  Consequently, the validation of the accuracy of the Truth in Lending Act APR disclosures, as well as state-specific usury maximums for many lending institutions for bulk purchases, is a very complicated, tedious, and manual process.  Validating one, no problem.  Validating thousands of loans is a different dynamic altogether.

At Carleton, we have the ability to take electronic data from a proposed bulk portfolio purchase and streamline the validation process.  No, every detail and potential risk factor cannot be easily identified and vetted. However, a creditor can confidently move forward with a portfolio purchase with less anxiety, having assurance that the potential portfolio purchase of bulk loans has accurate TILA APR disclosures with none exceeding the state-specific usury cap.

Bottom line…Making a compliant buying decision has never been easier with a little help from Carleton.

Entering into 2016, three states published prima facie credit insurance rates will be changing.  Specifically, Colorado, Nebraska, and Virginia promulgate new prima facie rates for credit life and A&H.  These specific changes within a three-month period is a distinct departure from the recent historical trends of little movement in published prima facie rates.

In Virginia, credit life rates increased on January 1st, which also departs from the approximate 20-year trend of steady rate declines, while A&H rates decreased.

Colorado regulation, which contains a virtual labyrinth of rates for specifically designated coverage types, will also see the general credit life rates increase on February 1st while credit A&H rates remain unchanged.

The Nebraska Insurance Department Bulletin effectively reduces both credit life and A&H rates effective March 1st.

Carleton will closely monitor prima facie rate as this may be an active trend.

APRWin, from the Office of the Comptroller of the Currency, is a mainstay in compliance circles.  It is a great tool, and, like nearly every field examiner in the Western Hemisphere, we use it nearly every day, right alongside our own Carleton APR validation tool. APRWin, however, is software, and all software makes trade-offs between being usable and being comprehensive; making best guesses as to the user’s intent in unusual cases. In the unusual case where payments are due on the last day of one month, but not the last day of every month, APRWin guesses wrong.

Consider a loan with $500.00 of Amount Financed as of July 31, 2014, with four payments of $150.00 each due monthly beginning August 28, 2014. Everyone would agree, and APRWin correctly determines, that there are twenty-eight days to the first payment. The APR (according to Appendix J’s actuarial method, which is all APRWin knows how to do) is correctly computed as 95.2080% (to four places).

Wouldn’t you think the APR would be exactly the same if you simply moved the entire loan, advance and four payments, six months earlier? APRWin doesn’t!

Okay? Not so fast. APRWin, in the absence of further information, decides that this is one full calendar month (well, it is for the first interval), and that the subsequent payments are also full calendar months back to the contract date.  With the rest of the payments scheduled on 3/28, 4/28, and 5/28, we know that isn’t so, but APRWin doesn’t.

 

Now that’s an overstatement that will get an examiner ex-“cited”! This can be somewhat ameliorated by entering the three remaining payments as a separate stream, but APRWin still miscalculates the time for the first payment and declares an “overstated” APR by 0.7428%.

The problem arises from exactly one shortfall: APRWin never asks for the scheduled payment date, and can only ask for the actual payment date. In Appendix J, section (b)(3)(iv) states, “If a series of payments (or advances) is scheduled for the last day of each month, months shall be measured from the last day of the given month to the last day of another month” (emphasis mine). With no way to ask for the scheduled payment date, it assumes that a payment on the last day of its month is scheduled for the last day of every month.  Your dad taught you what ‘assume’ makes out of you and me, right?

A savvy examiner will recognize this, and hand-calculate the Unit Periods and Odd Days rather than relying on APRWin to do so. A savvy lender, presented with an overstatement notice (and, since APRWin always calculates a longer time period, it always understates the true APR), will ask the examiner to do so when a loan’s payments are on the last day of some but not all months.  You can move this same loan to 3/31 with payments scheduled on the 30^th of the next four months and see the same behavior, just not as dramatically.

During a recent training session for a group of newer employees  (fairly new by Carleton standards, since our average tenure is approximately 18 years of service), we began discussing the parameters integral to computing a loan payment.  I then asked:

“Ok, so now we agree on the parameters that will drive the payment calculation. If we’re a new company and I give you the task to program this into a viable computing routine, where do you go to find out how to compute a loan payment?  An extremely quiet 30-second impasse filled with blank stares and embarrassed smiles ensued, followed by a collective shrug of the shoulders “we’re really not sure”.

It is a true statement in this business of creating consumer lending calculations that there is no granular level standard textbook for computing loan payments.  Yes, you can start with the PV of an annuity formula.  But that is incredibly generic and limited for today’s lending industry and its ever-expanding “exotic financing” outlook.  For instance, you can’t compute daily simple interest by formula. It is the broadening and refining of that basic equation that is the key to the payment computing kingdom.

So, it’s no wonder that we regularly see loan transactions from systems (LOS and DMS) that incorporate payment calculation routines where interest accrues by the “actuarial method”.

In this context, the statutory definition for the term “actuarial method” is usually something like “as defined by the Federal Reserve Board in Regulation Z 12 C.F.R. Sec. 266 that implements the Truth in Lending Act.”

Since the Truth in Lending Act requires an APR to be computed for nearly every consumer credit transaction, what safer way to build a compliant payment computing routine than to manipulate the Appendix J algorithm for computing a Reg. Z APR, from finding a rate to finding a payment?  “If I just follow that same template, how can I go wrong?”  Or so the thought process goes.

One major stumbling block to that solution is that the Appendix J algorithm incorporates the inherent compounding of interest.  Nowhere in the definitions, variables, or other explanations is that fact stated, but it’s there in the math.

Given that the compounding of interest is generally held to be against public policy in many jurisdictions and the fact that compounding increases the effective yield of the transaction, it can be a precarious practice at best.  Very often, compounding must be both expressly allowed by statute and clearly agreed to by the parties involved.

I often wonder what percentage of programmers, loan officers, and compliance officers are even aware it’s there, inherent in the math of the method itself anytime a first interval is longer than a regular period.

Even though a few states, like Louisiana, expressly allow compounding by authorizing the actuarial method of interest accrual in their statutes, the real question for lenders should be “how well will this play in front of Judge Wapner at six o’clock?”

One phrase regarding compliance that I have come to embrace over the years is “The Greatest Risk come from those things that have no history of problems”.

Had an interesting phone message from a colleague attending a Mortgage Bankers Conference yesterday.  It went something like this:

“Just got out of a really interesting session.  A great deal of debate and discussion on being able to validate the TILA APR at mortgage closing with the new mortgage disclosures.  Each of the panel members computed a different rate for the same loan. The animated discussion was about which one was right.  There is great concern that at closing, you have to gather documents from multiple parties and pull information together from these various documents.  One mistake and you have a situation.”

Sometimes, it takes a while for certain chickens to come home to roost.

Back in the fall of 2010, when the interim rule about what, at Carleton, we call the “MDIA Payment Disclosures” proposal was published, it was clear that one of the deficiencies of the attempt to overhaul mortgage disclosures was that the contract itself did not display the actual payment schedule that other TILA disclosures were derived from.

In short, there isn’t the proper information on the contract disclosure to compute/validate the TILA APR.

Since our focus is on the calculations and disclosures, that fact was a glaring drawback in our view.  We opined exactly this issue to the Federal Reserve Board of Governors, they actually promulgated the original interim rule, during the industry comment period.

At the time in exploring this issue with regulators at both the national and state level, we got pretty much the same response, “Well, examiners have to look at the HUD-1 anyway, they can get the payment information from there”.

After 29 years in the Carleton Research Department, I can’t even tell you how many times I have worked with auditors, compliance officers, attorneys, and examiners who believed an APR value was incorrect only to realize the issue was with inaccurate data entered into the APR check program they were using. This when all the payment information required was still in the Fedbox on the contract.

Now the expectation is to pull critical information from other documents?  Have you ever noticed how many numbers reside on a completed HUD-1 form?

It just seems that the new disclosures have opened a huge door on the opportunity for inaccuracies ranging from simple lapses to egregious errors on the part of auditors who now have to play detective with an assortment of documents.

More information isn’t always better information.

*If you would like to view Carleton’s official comment letter to the FRB concerning the MDIA Mortgage Payment Disclosures, click on the link below:

Carleton’s Official Comment Letter

Often, we fall prey to not being able to see the forest because of the trees.  The details overwhelm us and we miss the proverbial big picture.  When it comes to the compliance of your credit calculations, I’m afraid these days the opposite may be taking place.

The nuances and parameters driving the calculations that create credit disclosures reside at such an esoteric, granular level that a long list of “900 lb. Gorillas” is currently over- crowding the room — disparate impact, fair lending, ATR, QM, UDAAP, HMDA data — none of which are focused on the integrity of how you calculate your traditional disclosures.

The consumer credit mathematics is often overlooked and, yes, taken for granted that it’s “just math” and influenced by the “we just need to find someone with an advanced mathematics degree” mindset.

But if you have ever spent much time trying to unravel your institution’s settings, parameters, interest accrual methods, rounding options etc., you know the consumer credit math is its own animal when compared to mainstream, everyday arithmetic.

With the expansion of regulatory requirements, it is paramount that all facets of a lender’s operation “cross foot and balance,” so to speak. We are calling that process “alignment.”

Alignment means the same methods are used throughout the life of the transaction.  The narrative description in the lending agreement states that the lender will compute and accrue charges according to certain rules and parameters. The disclosure numbers populating the agreement are the product of employing those rules and parameters. The back-end servicing calculations actually collect the charge in the exact same manner.  It all matches.

Sounds simple, right?

You would be surprised how often we see lending documents state that “charges will be computed on a 365-day year” in the promise to pay section, yet the numbers populating the form are generic, periodic, 30/360, HP 12C type calculations.

Those generic calculations are much simpler to program and compute and, most likely, have been embedded in the loan origination system for decades.  We’ve got an incongruity right off the bat and we haven’t even gotten to the servicing calculations yet.

There is a train of thought that “it all comes out in the wash” with the interest-bearing, a.k.a. “simple interest”, transactions that dominate today’s credit market.  “The consumer isn’t going to make all of their payments exactly on due dates anyway, so what’s the big deal about the regular payment?”

Well, besides the advent of debit/e-check/ACH payment proliferation rendering the previous adage practically unserviceable, there is the battle to define, determine, and evade the newly created CFPB two-headed specter of “deceptive” and “abusive”.

What better defense than all phases of your operation accurately and consistently portraying the contractual obligation between the lender and the borrower?

It might be worthwhile to step out of the dense compliance forest for just a moment and take a close look at the tree that houses your system calculation engine.