Category: Thought Leadership

The thought for the day centers around the seemingly ubiquitous client request of  “Why is my payment different when I use your software”?  The specifics of the answer to that question permeate the core of what makes consumer credit math a more intimidating subject than at first glance.  Bottom line: there is no such thing as a single universal payment amount for a given set of loan data.

Obviously, judging from the construction of the opening question, the client has an expectation as to what the payment should be for a specific loan amount, term, and interest rate.  Very often, that expectation is driven by the results from the ancient Monroe desktop that has been sitting on the file cabinet for the last 22 years.  “Everyone uses it,” so the payment must be right even though, at this point in time, no one remembers what particular parameters were programmed into the box in 1989.

Contrary to what may seem like conventional wisdom, most lenders, point of sale dealers, and representatives generally have a number of programs and applications that can take input data and generate a payment and other disclosure values.  So, without coordinating the nuts and bolts parameters of the math involved, the chance of two or more different pieces of software matching payment calculations on a regular basis is actually slimmer than you may think.

Payment calculations are driven by the process of prospective amortization.  The goal is to arrive at the payment that will amortize the loan, accruing interest at the stated interest rate over the stated maturity of the loan.

Unlike the actual payment history, the amortization process used in creating a payment must assume all payments will be made as scheduled.  That is the only information available at the consummation of the contract.

The dominating wild cards in the process are the interest accrual method and the time calendar in use.  In order to move through the theoretical amortization process, we have to have rules.  Those rules are often lumped together under the umbrella “interest accrual,” but to really be accurate, it takes more delineation than that.

Time calendars are the biggest reason systems produce differing payments for the same set of data.  The recognition of time periods is crucial in understanding if the quoted payment will amortize the credit transaction.

In determining how prospective interest will be assessed on the scheduled outstanding balances between payment dates, it is a matter of recognizing the periods between two prospective dates, or events.  Is the time period from today, April 26th, until May 26th one month and the annual interest rate will be applied as 1/12 to the outstanding balance?  Or is it 30 days?  Will the rate be applied as 30/365 of the rate times the balance?  30/360?  or perhaps 30/366 if it is a leap year?    As you can see, it slices and dices in a number of distinct styles and models.  All potentially producing a distinct payment value depending on the loan data involved.

That is why, after 26 years of working to define precise specifications to produce accurate payments, I bite my tongue when I hear “Well, we use a 365-day year”.  That indeed is a truthful description of the calendar on my wall, but it doesn’t provide enough information to decipher a lender’s expected interest accrual process.

If we’re focusing on “365”, does that mean the 26th to the following 26th is a month and any days outside that month earn interest at 1/365 of the annual interest rate?  Or does that mean to assess 1/365 of the annual rate for 30 days if the time period is April to May? 31 days if May to June, etc.?  And, does “365” really mean we’ll exclude leap year when it occurs?  Alone, “365”  creates many more questions than answers.

For a subject that, from the outside looking in, at first appears simple and plain, the complexities and details greatly outnumber the obvious.

I’ve learned not to jump on the bandwagon too swiftly and declare a payment “wrong” for a set of loan data.  Instead, “different” is a much more accurate and realistic approach when viewing a disclosed payment and attempting to evaluate if it is “right”.  You have to understand the rules the payment computation operates under before making a judgment call.

One question we field on a weekly, some weeks daily, basis revolves around the Truth-in-Lending APR disclosure in the “fedbox” being a different value than the originating interest rate. A different value, meaning the interest rate was 10.00,% but the disclosed TILA APR is 9.98%.

The view in the consumer finance industry that “the APR and the interest rate should be the same if I don’t have any fees” is not only predominant but has reached an urban legend type of status. Too many times, the answer to my inquiry as to why the above statement is true has been “because it is”. Sound logic.

In reality, the two rates are truly distinct values. They have separate purposes and functions. One is to compute the interest charge for the transaction according to the lender’s choice of accrual, which is in step with their particular philosophies and policies; the other is to measure the cost of credit in a standardized fashion in an attempt to provide consumers with a yardstick in comparing competing deals.

The interest rate is the dominant factor in determining a loan’s magic number, the monthly payment. The prospective interest plus the loan principal determines the scheduled total of payments.

Once the payments and all the other disclosure numbers have been computed, then the Truth-in-Lending APR can be accurately computed and disclosed. It is entirely a back-end number. It is often erroneously thought that the APR creates or drives other loan values, but it does not. It merely measures the result of the other computations and provides a common barometer for the consumer to evaluate and compare credit deals.

The changing nature and operations of the lending industry have brought the differing characteristics of these rate values out into the light. For many years, the TILA APR produced a rate that was always the same value as the interest rate and it still will on occasion. But in particular, the advent of “simple interest” transactions with daily interest accrual has changed the landscape dramatically.

Back in the day, when interest was nearly always computed on a monthly basis, aka “360-day year”, the APR and the interest rate, in the absence of pre-paid finance charges, would end up with the same value.

That is because Regulation Z mandates that the APR be computed on a “unit-period” basis. (We’ll disregard the U.S. Rule implications here; that is another entire blog that could stretch for several city blocks) So when repayment terms on loans were predominantly monthly in the industry, both the interest charge and the APR were computed monthly. A 10% interest rate would work out to be a 10% APR. Most of us who have been around this industry for 20 years or so remember that “it was always that way”.

Think about today’s lending practices and the prevalence of “simple interest” transactions. One of the hallmarks of simple interest is computing the interest charges on a daily basis. Each calendar day between scheduled payment dates accrues interest at 1/365 of the annual rate. So, that daily interest produces a dollar interest charge that, in the absence of fees, becomes the TILA finance charge by definition.

When the APR recognizes that the loan’s total dollar charge, it assumes time periods are monthly and computes an APR accordingly. Interest computed daily and an APR computed monthly are not “apples and apples”.

However, remember that one of the roles of the TILA APR is to standardize the cost of credit rate and provide a “level playing field” gauge of the credit cost regardless of differing parameters, such as interest accrual, employed by differing lenders.

If the dollar interest charge for 36 months on a daily basis is greater than the dollar charge for 36 months on a monthly basis, it only makes sense that the APR would be higher.

It is not unusual for a 14% interest rate computed on a daily basis for a monthly loan to yield an APR of 14.02%. Both rates are accurate, they simply operate with different rules.

One important caveat for lenders with a policy of operating at state maximum interest rates is recognizing when the practice of daily interest accrual may produce an APR that exceeds the computational rate. Many states have statutory language that equates the maximum rate with the TILA APR. Some states regulate interest and some regulate the equivalent of the TILA finance charge. Like so many things in today’s world, what used to be simple isn’t necessarily so any longer.