Category: Thought Leadership

There has been a marked increase over the past couple of years in credit plans being tailored to the payroll frequencies of respective borrowers and retail buyers.  Creditors like the security of scheduling payments in accordance with how their customers get paid by their employers.

Sounds simple enough, but like nearly everything surrounding consumer credit calculations, some of these options can be a bit tricky as far as producing accurate Truth in Lending disclosures.  Particularly, the annual percentage rate.

Take, for instance, borrowers who get paid only once a month.  Typically, that event occurs on the last day of every month. Appendix J of Regulation Z has particular language dealing with payments scheduled on the last day of each month.  Like many other scenarios, the techniques used to enter and exit the month of February generally take special code to account for the fact that the month on either side of February contains 31 calendar days while February itself has only 28, or perhaps 29 if it’s a leap year.

Even more perplexing, and nearly universally misunderstood, are the rules for computing the APR when the repayment period is “semi-monthly,” constituting 24 payments in each calendar year.  It doesn’t take an advanced math degree to figure that 2 payments per month during a year that contains 365 calendar days is going to create some unique time periods.

Too often, we see systems encounter the pitfall of declaring a semi-monthly period to be 15 days long.  Part of that is fueled by the language in Appendix J for determining the fractional unit period in a semi-monthly scenario by dividing by 15.  That value is evident, so programmers run with it.

However, remember that the Appendix J unit period concept is the “common period that occurs most often”.

If a computing routine declares that a semi-month period is every 15 days, then the period occurring most frequently, and hence the unit period for the APR, is exactly that: 15 days.  And…that is not a “semi-month”.  24 payments per year, every 15 days, still leaves 5 calendar days unaccounted for.

A 15 day unit period will produce a distinct APR value when compared to one using a semi-month for the same transaction data.

It’s an easy trap to fall into and we see the results from originating systems on a regular basis.

We’ve spent the last couple of months putting the finishing touches on revisions to the Carleton “HOEPA” module.  Like any software update that deals with regulations, the bulk of the changes were fairly straightforward.  It is the nuances “around the edges” that always make life a bit more interesting.

For a company like Carleton that specializes in consumer credit math, the big ticket items were the structural changes to the “APR Trigger” and “Points and Fee Trigger”.  Those two items represent the anchors of our role in the HOEPA determination process.

The  APR Trigger now features lower percentages representing the threshold.  The 8%/10% values currently in place will be replaced by 6.5%/8.5%.  The other major change is that the rate used for evaluation will become the Average Prime Offer Rate, as published on the FFIEC website.

Those were obvious material revisions to the current regulation.  A more subtle change is that the “APR”, compared to the APOR rates, is no longer the computed and disclosed Truth in Lending Act APR for the transaction.  Instead, the interest rate is now used for comparison.

Yet the label is still referred to as “APR.”  We fight the battle constantly to use precise and accurate labels to enhance clear communication.  Then, the regulation itself promotes an “APR that is not an APR”.  Ya gotta love administrators.

It appears that one of the goals of the APR Trigger restructuring is to bring the HOEPA threshold process more in line with similar ones for the HMDA rate spread and HPML determinations.

One of the nuances affected, more or less by implication, is that by adopting the APOR standard, the determination of a “comparable transaction” changes for adjustable-rate loans.  The comparable transaction is no longer based on the life of the loan.

The Points and Fees Trigger has been revised and now has a tiered rate structure with the percentage being 5% for loans under $20,000 and 8% for loans of $20,000 or more.  There is also a new “floor” amount of $1,000 associated with the 8% fee percentage.

It looks like January 2014 will be a busy and interesting month as a number of new regulations go into effect.

The regulatory climate is about as uncertain and volatile as I have seen it in my 28-plus years at Carleton.  Of course, the big dog in the room is the CFPB administering the Dodd-Frank Act provisions.  It is a task of such enormity that it’s obviously being done piecemeal over a several-year period and leaving most of us with a sense of impending, “I wonder what’s next.”

We have also seen a flurry of activity on the state level over the last several months.  Much of it actually impacting charges, disclosures, and calculations.  That is something we haven’t seen much of over the last 10 years or so.

The crush of dealing with some new type of regulation is overwhelming at times as lenders face new requirements from varying directions.

Like many who serve the consumer credit industry, we have been counseling our clients to “get ready” and “be prepared” for what’s coming by taking stock of their current compliance program.  That, of course, includes the often overlooked area of credit calculations and disclosures.

As we field more compliance-related questions, I am always a bit surprised that the “Maximum APR” viewpoint is still so prevalent in the industry.

If it were only that easy!  The fact is, most consumer lending statutes regulate the dollar amount of the charge, whether it’s referred to as interest, finance charge, or time-price differential.  The dollar charge is created by the application of the published maximum rate to the outstanding balances of the transaction.

It’s important to note that a TILA APR computed by the actuarial method is going to use the charge accrual calendar prescribed by Appendix J to Regulation Z, often referred to as the “Federal Calendar” (Fed Cal).

The calendar prescribed by a specific state statutory provision, more than likely, does not use the Fed Cal for determining the maximum charge.  A few states do use the definition of  “actuarial method” in describing how state charges are to be computed.  However, in most cases, they do not always comprehend the detailed level specification that the actuarial method contains inherent compounding of interest.

So, if the state-prescribed calendar for maximum charge in the statute differs from the one used to compute the TILA APR, the APR is not an accurate barometer of compliance with a state statutory provision on the maximum charge allowed.

Also, the TILA APR is generally a two or three place value, it has to fit in the Fedbox allotted space, which means it is a rounded value.  Quite often, the TILA APR, rounded for the purpose of display, can provide a false sense of security or produce a premature overcharge warning for a specific set of loan data.

It is possible for a disclosed 21% TILA APR to produce a state-sanctioned finance charge that exceeds the prescribed 21% published statutory maximum rate and thus represents a violation.  It’s all in the details.

It’s been an active month for regulation, to say the least.  A minor deluge of state-based July 1st law changes mixed with the CFPB’s upswing in both proposed and final regulations has made for an awful lot of reading, analysis, and retrofitting of existing programs.

The CFPB saga regarding the attempt to implement the Dodd-Frank prohibition on single premium credit insurance/deb cancellation products with real estate transactions has taken its latest turn with their clarification proposal on June 24th.  A good deal of that appears to be in response to the industry’s requests for a clearer meaning of the “calculated paid in full on a monthly basis” clause in the original CFPB proposal.

The June 24th proposal appears to center around two broad definitions; that of ‘calculated on a monthly basis’ and the definition of ‘financed’.  Make no mistake, there are other issues addressed, along with an almost endless list of granular subplots, but to an entity like Carleton, where the credit math is a first priority, these two points dominate the initial discussion.

One additional point of interest where it appears the effect of the mathematics involved is not clearly understood is in the CFPB expectation that credit transactions with traditional MOB insurance (or monthly debt cancellation) should create the same interest charge as a comparable transaction with no insurance.

From an “outside looking in” perspective, that doesn’t seem to be an unreasonable presumption.

The fact is, though, that the traditional objective of supplying an equal monthly payment to the consumer, and the math required in that process, renders the ideological goal of identical interest charges an impractical impossibility.

The equal monthly payment containing MOB insurance is made of three parts; computed insurance premium, accrued interest, and principal reduction.

The insurance portion is found by multiplying a rate times the outstanding loan balance each month, so that portion is variable.

The remaining principal and interest components must also be variable to arrive at an equal sum each month.

The kicker is that once all those variable pieces of the payment are rounded to dollar and cent values in order to make the payment “collectible”, the dynamics of the transaction change.  Merely the monthly insurance portion produced by multiplying the rate times the outstanding loan balance each month is going to be a value like $13.125812964… and on to 32 decimal places.

Rounding the insurance piece to $13.13 produces one effect, rounding to $13.12 another and the effect becomes cumulative throughout the life of the transaction.

That rounding effect generally does slow the liquidation of principal a bit and produces a slightly higher total interest charge. Whether that slowdown in principal reduction is ‘significant’ is probably in the eye of the beholder, but it’s simply the nature of the beast.

So, the expectation of “identical interest charges” and the idea that credit insurance premiums are calculated on a monthly basis “if they are determined mathematically by multiplying a rate by the actual monthly outstanding balance” seem to work at a bit of a cross purpose.

From the first introduction of a bill to promote “Truth in Lending” in 1960 by Senator Paul Douglas of Illinois to its adoption and enactment in 1969, the first principle of the Truth in Lending Act is to ensure the American consumer is given the whole truth about the price he is asked to pay for credit.

I think sometimes that simple fact gets overlooked as layer upon layer of extra and extraneous data, information, and operating policy emerge to impact business practices for a consumer credit contract.

We’ve discussed several times that differences between values of “interest rate” and “APR” seem to be making constant waves throughout the consumer finance industry. One reason is that it simply represents a historical perspective that “they’ve always been the same”. But it’s important to keep in mind the intent of TILA.

When I read the “declaration of purpose” section of 15 USC 1601(1) (the Truth in Lending Act), I see:

“The informed use of credit results from an awareness of the cost thereof by consumers. It is the purpose of this subchapter to assure a meaningful disclosure of credit terms so that the consumer will be able to compare more readily the various credit terms available to him and avoid the uninformed use of credit…”

The intent is for the Truth in Lending Act, along with its accompanying disclosure values, to be a DISCLOSURE LAW. Tell the consumer the TRUTH by being precise and accurate in calculating and disclosing values. That sure appears to be the beginning and end of it.

We recently encountered a situation where an indirect lender refused to purchase a RISC because the promissory note section of the contract showed an interest rate of 7.99% and the TILA Fedbox APR was 8.00%.

Both values were accurate. The computational interest rate was 7.99% and that rate was applied on a daily basis, “365-day year” to some, while the resulting TILA APR employed the Federal Calendar that is mandated with an actuarial method computation. The difference in methods caused the slight differences. It was slight, the computed APR value was 7.997% which rounded to 8.00%.

The lender’s determination was that having two different rates appear on the contract was deceptive.

That rings a familiar tone, doesn’t it? More than likely, an echo of much of the CFPB dialogue stating “abusive and deceptive” practices will be a point of emphasis with the bureau.

Although regulations specifically targeting retail installment financing have yet to be established by the CFPB, the prospect of such regulations seems to weigh heavily upon those who set policies and practices in the consumer finance industry.

If computing an accurate TILA APR that coincides with an accurate portrayal of the lender’s business decision to accrue interest income on a daily basis is deemed “deceptive”, what alternatives does that leave?

Lenders no longer have the choice to accrue interest income at their discretion? All lenders should be locked into an interest accrual method that resembles the Federal Calendar so as to match the APR? TILA disclosures were designed to “level the playing field” when it came to the diversity available to lenders in business policy, not the other way around.

It seems some of these purely subjective declarations of intent have lost sight of the purpose and goals of the Truth in Lending Act.

A complicating factor in this particular case was the servicer’s practice of exporting the TILA Fedbox APR value into the servicing system to actually earn interest. More on that dubious process next time.

With the inception of the 2002 HOEPA revisions, we saw a dramatic increase in the use of outstanding balance (aka “monthly remittance”) credit insurance premiums in conjunction with closed-end credit transactions.  That, of course, was due to the inclusion of single premium credit insurance premiums being included in the points and fees trigger introduced with the Act.

Since that time, outstanding balance (aka “MOB”) insurance has continued to be a staple employed in the consumer finance industry when credit insurance is offered on a closed-end product.

At first glance, the coverage seems rather simplistic; the monthly premium is remitted along with the monthly P&I portion of the payment on the due date.  But, like so much in this industry, there are some properties inherent in MOB coverage that are not particularly self- evident.

Monthly payment calculations, including traditional MOB insurance, are not as straightforward as simply taking a “no insurance” payment and adding the monthly premiums to that amount.  That is because the majority of lenders desire the amount due by the borrower each month to be a level amount and not one that is constantly fluctuating.

Think about the premise of “monthly remittance” premiums; the monthly premium is computed each month by applying a rate to the outstanding balance.  The outstanding balance of a loan decreases by the amount of the principal portion of the monthly payment applied.  So the monthly premium amount is determined on the basis of a declining balance, meaning the premium amount will change every month.

If the goal is to provide the consumer with a level and equal total amount due each month, then the variable premium amount needs to be combined with a  P&I payment that also changes each month in order to arrive at that level total payment the borrower pays.

That process of combining a variable premium payment with a variable P&I payment each month to arrive at the total payment amount gets quite complicated.

Also, finding the monthly insurance by multiplying a rate times the balance produces a mathematical number that, in our code at least, is potentially 32 decimal places long.  That’s simply the math involved.

In order to have a practical amount to collect, the insurance needs to be rounded to a dollar and cent value each month.  That’s, for instance, 60 roundings in a 60-month loan or perhaps as many as 120 if both life and A&H are involved.

That’s the reason that you can’t directly compare the interest from a no insurance transaction to one with identical parameters that has MOB insurance coverage.  It is not “apples and apples.”

The rounding of the premium(s) each month to a dollar and cent amount can slow down the liquidation of the principal of the loan, even though it is ever so slight.  The result is that the interest from a loan with MOB coverage is slightly higher than that of its counterpart that has no insurance coverage.

Since Regulation Z allows voluntary MOB premiums to be excluded from the finance charge, only the P&I portion of the payment is used in the calculation of the APR.  That means 60 separate and differing payment streams to compute the APR for a 60-month loan.  And once again, the rounding of the P&I payment each month influences whether the computed APR, when devoid of prepaid charges, ends up as the same value as the starting interest rate.

The next time you hear someone say “it’s just rounding”, remember the implications can be quite significant.

2013 has begun with a deluge of questions, issues, and investigative queries from a diverse cross-section of lenders in the consumer finance industry about the specifics of proper APR computations.

The “devil” is in the details and the recent plethora of issues presented had indeed “drilled down” to the very unique and peculiar properties of Appendix J to Regulation Z and the accompanying definitions of terms and concepts.

Remember that Appendix J was created to serve as the “how to” for APR calculation to fill a void left by the original Regulation Z, which described the concept of the APR but left too much regarding the detail level nuts and bolts issues open to interpretation.

It was also formulated during the late 1970’s when the vast majority of calculations were fairly generic and repayment was primarily monthly in nature. Those factors definitely influenced the viewpoint of the Consumer Affairs Committee in creating Appendix J.

Some random thoughts concerning the issues currently creating a buzz in the consumer finance industry:

• The APR isn’t the interest rate. We’ve discussed this in previous blogs and it continues to be a prevalent issue. Keep in mind that nowhere in Appendix J or Reg. Z does it state that “if no fees are present, the APR will be considered accurate if it is the same value as the interest rate”.
• If that is the case and accuracy is achieved by a simple eyeball test, why does Appendix J contain 16 pages of detailed definitions, variables, and algorithms? Since the majority of consumer lending transactions don’t contain prepaid finance charge fees, what’s the point?
• February really does throw a wrench into any logical view of how time periods should be measured. The edict to use the last day of February when payments are scheduled for the 29th or 30th of a month creates some interesting scenarios. If the contract date is January 29th and the first payment date is March 30th, how many whole unit periods does that produce by the Federal Calendar?
• The trend to tie repayment to the borrower’s payroll cycle is causing a tremendous amount of “gnashing of teeth” in trying to make sense out of two payments scheduled per month within the context of a 365-day year, months that have 31 days, and a “most commonly occurring” time interval between events.
• Back to point No. 1: If daily interest accrual (aka simple interest) produces a total interest charge of $55.08 for a twelve month loan without fees, and monthly interest accrual (aka unit period) produces a total interest charge of $54.92 for the same twelve month loan with no fees, shouldn’t the APR be higher for daily accrual (10.02%) than for monthly accrual (10%)? Seems to me like Truth in Lending is working as intended: larger finance charge, larger APR.
• Servicing systems that employ the practice of pulling the contract APR (Truth in Lending APR) into the core system to process payments should perform an evaluation of the parameters at the detail level. Those processes were probably put into place years ago when interest was computed monthly and was more closely associated with the APR calculation itself. Simple interest properties have changed that landscape enormously.
• The original intent of the Truth in Lending Act APR was to serve as a basis for consumers to compare the cost of competing financing transactions. The APR was not meant, nor designed, to measure the loan’s profitability for the lender. The mathematics behind the calculation bear out that the APR is a great visual graphic, but a poor indicator of individual loan profit. It is unfortunate that it gets used in that context so often when discussing the regulation of the consumer finance industry.

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?

It’s pretty obvious that the subject of interest rates versus APRs 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 structures allow charging a stated handling charge per month of the contract.  The lender still has to compute and disclose an accurate APR.

But besides 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 mindset.

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 rates, 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%.

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.