Category: Thought Leadership

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’s 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 the regular payment and the computed odd final payment.

Twenty years ago, the code to find an actual day interest, a 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 the final 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 retrofitting.

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, February 29^th.  While leap day and leap year are 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 firsthand 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.

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 lender’s 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 rollout 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 retooling 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 that when it comes to calculations and disclosures, 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.

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 misuse, of labels, slang, jargon, and other esoteric terms not only makes it difficult to communicate in this industry, but 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 the “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 charges.  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 the 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 was 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 the 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 premiums or ancillary product charges.  The same rules for irregularities, however, continue to apply.

Like a lot of 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 also adjust.

The 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 its accuracy and viability.

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 the 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.

An interesting discussion I often have with members from both the industry and the regulators is the proper way to decide if a computed number is “right”.

Generally, we see two schools of thought on this subject: one that seeks to “re-originate” the transaction in question and match the disclosed results, and the other that seeks to validate computed numbers by a predetermined set of rules.

I’ll admit here at the outset of this discussion that I am an advocate of the second position and feel it is the proper way to determine if a credit calculation is accurate and thus “correct”.

The real key to creating a loan transaction from scratch is the integration of interdependent computed values into the transaction at large. That may seem like a mouthful, but the premise is something like this:

I want to know if the single premium credit life premium of $374.92 is correct, but the premium coverage is gross payoff, so the premium is based on the total of payments. I can’t figure out the total of payments until I compute the payment. The payment can’t be computed until I arrive at the principal amount, but the principal amount includes the life premium so…

You see how it goes. The circular nature of numerous iterations is at the center of the requirement that all computed values be integrated accurately into a credit transaction for it to be valid.

An attempt to start at the beginning, with say a $5,000 proceeds value and re-create the transaction exactly, and also match the premium, can be a truly daunting and perhaps superfluous task.

First, the interest accrual calendar has to be the same as the transaction in question, along with the payment rounding, of course. Speaking of rounding, all intermediate rounding of the life rate itself, premium values, and accrued interest amounts must also match to the penny.

So if it’s a 60-month transaction, I’ve got at least 3 things that have to match exactly 60 times in a row.

Remember that the value you want to prove is correct comes from software utilizing specific code written by a specific programmer or developer. How many programmers do you know that write code identically, even within the same office, let alone 1,000 miles apart and working independently?

And, if I don’t match, which of those three potential variables is out of sync? Or maybe two of the three? There are way too many variables and unknowns to try to coordinate in order to get an accurate picture. Sometimes the results may match, but you can’t be absolutely certain it’s for the right reasons.

A much better approach is to know the properties, parameters and pertinent variables included in the transaction and use the true disclosed loan values themselves to prove right or wrong.

For instance, in the above example, if the gross credit life rate was $0.40 per $100 per year and the computed and disclosed monthly payment was $310.89 for 60 months, then the proper premium is $373.07.

Now, whether the disclosed contract value of $374.92 is acceptable in light of this evaluation is another level of scrutiny, and a different topic altogether, that I won’t try to address at the moment. For today, I’m sticking to the “how to” process.

However, in this validation scenario, it is clear what the proper premium is for the rate filed and the disclosed monthly payment of $310.89. This validation has used the actual contract payment, amount financed, and filed insurance rate to arrive at the result.

It doesn’t matter whether the mission is validation of insurance premiums, maximum allowed interest charges, or contractual rates of charge, a key ingredient is the employment of the disclosed contractual payment amount(s).

The payment disclosed and agreed to in the contract is a major determinant of interest earnings and principal reduction for any given period during the transaction.

The imposition of a theoretical payment through the process of “re-solving” can skew the profile of the loan liquidation so that it no longer resembles the actual transaction. In that case, re-solving will produce a result, but not necessarily one that provides an accurate actuarial analysis of the calculation under scrutiny.

At Carleton, we use the process of amortization to provide a precise and accurate validation of the data on a consumer credit contract. We constantly evaluate whether we are keeping our “eyes on the prize” when it comes to ensuring our clients are in compliance when using our calculations. The key is not to be distracted by available peripheral data and approaches that don’t really focus on the issue at hand.

A particularly key compliance component of our project definition process for new clients is the analysis of the properties associated with any fees paid by a consumer as part of a prospective credit transaction.

Unlike mortgage lending, where some fees have common labels and are universally understood, e.g., appraisal fees, title examination fees, property survey fees, etc., fees associated with personal loans, small loans, and retail sales aren’t always transparent based solely on the fee name.

Our Focus Is Two-Fold:

1) Determine if the fee is part of the finance charge for Truth in Lending disclosure purposes.

2) Determine if the fee is included in any regulated “charge” amount for the specific state maximum charge evaluation.

The heart and soul of the Federal Truth in Lending Act is really the dollar finance charge, aka “cost of credit”. When Truth in Lending first came into being, the basic rule of thumb was that “every fee is part of the finance charge, with a few exceptions”.  That has evolved over the last 42 years to a process of “some fees are, some fees aren’t” based on certain criteria.

State maximum rate statutes generally declare that any statutorily authorized fees either “are” or “are not” included in the maximum amount the particular statute regulates.

What is often confusing is that while an authorized “processing fee” in a specific state may not be included in the state’s maximum charge amount, that same fee is most certainly included in the TILA cost of credit.  To exacerbate the mental congestion that often accompanies trying to clearly digest and segregate two separate sets of rules is that the label used for both state and federal purposes may be identical; “finance charge”.

So, for our purposes of making sure both state and federal calculations are accurate and compliant, we do need to know the name/label of a particular fee, but we’re much more interested in whether it is a TILA finance charge and part of the state maximum charge calculation.  Stating “we charge a service fee” is merely a starting point in the decision-making process of how to accurately portray that fee in a “live” credit transaction.

The Key Is to Remember That Fees Must Be Evaluated on Two Separate Levels:

1) Whether they are included/excluded for the state maximum charge evaluation.

2) Whether they are included/excluded for the purpose of determining the Truth in Lending Act finance charge dollar cost of credit.

These represent two separate processes to attain two separate compliance goals.

There are days when I absolutely hate the month of February.  And not just during that month with its sub-zero temps, dark days and endless snow, but when the fact that it has only 28 days wreaks havoc on system lending calculations.

We work to reconcile payment calculations from literally scores of other systems during our project definition process with clients and users. The key is to determine how a particular routine deals with February.  That is as challenging a diagnostic exercise as it gets.

Too many design characteristics draw from the outmoded “360-day year” methodology of 30 years ago.  February 1st to March 3rd may indeed be “30 days,” but it most certainly is not a calendar month and Regulation Z, for instance, certainly isn’t going to recognize that time period as 1/12 of a year.

It’s not merely February but the fact that months have different lengths in days.  A forgotten fine point is that while Appendix J to Reg Z says that “All months shall be considered equal”, actual calendar days have to be counted for fractional month periods.  That doesn’t jibe with many “360-day year” conceptions that we see put in use.

Like everything else, the devil is in the details.  Consider January 31st to February 28th; it’s a month when counting forward for interest accrual purposes, but can be a fraction of a month with the Federal Calendar in computing the APR.  That first glance at the dates can be deceptive.

When gathering information to define software, one of the critical areas for accurate disclosure is determining the nature of any fees that will be charged by the lender. A really popular industry description of specific fees is that “this fee affects the APR”.

It’s become clear that statement is intended to mean that a fee will “make the APR a different value than the interest rate” (Reference: The Interest Rate and the APR).  From our consumer credit math purist standpoint, every fee “affects” the APR.

All fees in a lending transaction are either in the Amount Financed (Truth in Lending Act definition) or the Finance Charge (also TILA defined).  The sum of the AF + FC equals the Total of Payments.  As a general rule, the AF and FC are mutually exclusive and collectively exhaustive.  Fees are either in one or the other, but they can’t be in both.

Consequently, a fee that is included in the TILA Amount Financed does indeed affect the APR calculation since the APR measures the relationship of the Amount Financed to the Finance Charge over the time period of the loan.

So, our goal in defining software projects is to help clients determine which fees can potentially be required to be in the TILA finance charge.

In the last few months, we have had a number of inquiries from clients about how to pass our calculation engine the right information for single advance, single payment transactions.

There seems to be a degree of uncertainty when dealing with these types of loans.

Maybe it’s because these types of transactions represent the simplest calculations that we do and the expectation is that the concept should be more difficult.  In reality, it is a linear I = P x R x T type environment and there aren’t the thousands of behind-the-scenes iterations that are necessary to compute a precisely integrated declining balance closed-end credit transaction.

It seems the first inclination is for a system to collect and pass us the information as though it were a monthly transaction with a series of $0.00 payments followed by one “balloon payment” at maturity.  For instance, a twelve-month single-pay loan would have 11 $0.00 payments and then one large payment of principal and interest.

That situation may seem analogous to a single payment transaction, but it poses two prominent issues with regard to the disclosure computations.

The first is that when assumed to be ‘monthly’ in nature, interest accrues on a theoretical monthly basis and presents potential rounding options.  Traditional near rounding, as in periodic transactions, can create an interest charge that is materially larger than a linear calculation where the only rounding is done once at completion.

The more significant issue is the Truth in Lending APR calculation.  The rules in Appendix J of Regulation Z recognize ‘events’ in order to establish a unit period for APR computation.  Payments of $0.00 are viewed as events, regardless of dollar amount, in order to take into account the time value of money.  That practice establishes the unit period for APR computation as monthly rather than the term of the transaction as prescribed in Appendix J.

The result is that the APR computed for a monthly unit period with 11 $0.00 payments and a final of $10,799.80 for a $10,000 loan is 7.719%.  Computed properly as a single advance, single payment loan, the accurate APR disclosure is 7.998%.  The difference of .279% is well outside the 1/8 of 1 percent tolerance Regulation Z allows.

There are instances where our communication is initially hindered by the use of labels.  Since we are creating routines to ensure compliance with regulatory requirements, the labels we use have strict definitions per the appropriate regulation.  A specific lender, however, may develop names for lending programs internally within their institution that have a more esoteric meaning.

We view “single payment” as a transaction where the borrower makes only one payment during the life of the loan.  We have seen the term “single payment” used to also characterize a loan program where interest-only payments are required and a single principal and interest payment is due at maturity.  Those two instances, both named “single payment,” require separate and distinct procedures for computing the Truth in Lending annual percentage rate.

It is vitally important to keep units of measure and other pertinent characteristics consistent when performing any consumer credit calculation.  Rather than “apples and apples,” the result may be a fruit salad not pleasant to the compliance taste buds of the lender.