We are pleased to bring you a post from Walter H. Hacket, III who will be a speaker at our special Mortgage Securitization and Servicing Seminar this September.
In the world of lending, fees are fabulous, but “Interest” is the name of the game. Banks began having issues with interest when the lending industry was hit with a number of lawsuits over interest calculations. A number of large California based banks were sued over the definition of the term “per annum.” The courts told the banks that a year is 365 days (except, of course, in leap years) and that was that (or was it?). Prior to the 1980s, the vast majority of “installment” loans accrued interest using a formula lovingly referred to as the “Rule of 78s.”
“Installment” loans were loans payable over their term in fixed payment amounts. When the final payment was paid the loan was paid in full. Typically, any loan that was for a relatively short term (5 years or less) and was available to consumers would be an Installment loan. The “Rule” used, as its primary example, a loan for a single 12 month period. If one were to add the numbers 1 through 12 the result is the number 78. The Rule was used to do even mor
In the days before Consumer Protection became buzzwords for politicians trolling for votes, Lenders treated interest in a very different way. Instead of bothering with things such as “accruing” interest on any sort of daily basis for installment loans, they “Added On” the interest for the entire loan period to the principal balance of the Loan and the borrower, therefore, knew precisely how much interest he or she would pay over the life of the loan. Lenders earned the interest by applying the Rule. If a loan were, in fact, for 12 months, then in the first month the Lender was deemed to have earned 12/78 of the total interest amount set forth in the Note. In the second month, 11/78, and so on down to the final month when only 1/78 of the interest would be earned. Problems did arise from “early payoffs” as Lenders could not lay claim to all future, unearned interest, and they would have to calculate how much of the remaining balance was principal and how much interest. While this problem gave rise to some very interesting solutions in commercial loans, it did something very different for installment loans – it made interest accruals on such loans a total mystery to the average borrower.
The BIG source of the mystery was the widespread introduction of “simple interest.” While the use of simple interest accruals had been in place prior to 1980, it was the growing enforcement of the Truth in Lending Act coupled with elimination of the Rule of 78s that were probably the largest reasons for its adoption in virtually all installment loans.
When simple interest was first introduced, many bankers and other lenders were less than enthusiastic – right up until they understood it. Lenders know that the average consumer will not make his or her payment on or before the date the payment is due. The primary reason for this is the notion of the “Grace Period.” A grace period is the period after which a payment is due when no late fees will be assessed. Consumers take this to mean their payments are “on time” so long as they are paid before the expiration of the grace period. In the world of simple interest, every time a consumer uses the grace period it makes a lender’s eyes see dollar signs and there’s a good reason for this – because the consumer is paying the lender MORE interest.
To understand this, it is important to understand the fashion in which simple interest loans accrue interest. Presume a loan of $100,000.00 with a nominal (“Note”) rate of 10%. If a borrower were to make no payments for an entire year, the interest owing on the loan at the end of the year would be $10,000.00. Of course, installment loans don’t work this way. However, to calculate “daily interest,” this is the presumption made. Therefore the starting figure is $10,000.00. While there are variations as to how one can make the calculation, the simplest way to calculate daily interest is to divide the annual interest figure by 365 (or 366 in a Leap Year). In our example, that calculates out to $27.40 per day (with rounding).
Let’s assume our make believe borrower, Carla Consumer, received her loan proceeds of $100,000.00 on July 15, 2010. Her first payment is due, at her request, on September 1, 2010 (owing to her pay periods). The interest that will be due on September 1, 2010 is the result of multiplying the daily interest beginning July 15 to September 1, 2010 (a total of 48 days if one actually counts the days beginning with July 15) or $1315.07. Presuming Carla’s Principal and Interest payments would be about $2124.70 and she made the payment on September 1, 2010, then her payment would first pay the interest, and the balance of $809.63 would be applied to the outstanding principal balance reducing it from $100,000.00 to $99,191.37. The daily interest on this figure is $27.18. Let’s presume however that Carla received a bonus on August 1, 2010 and decided to make her payment of $2,124.70 on August 15, 2010. This date is 31 days after she received her loan proceeds. 31 days of interest is $849.40. In this case the lender SHOULD apply the payment as follows – accrued interest, $849.40 and principal of $1,275.30 resulting in an outstanding loan balance of $98,724.70 for which the daily interest is $27.05. Let’s assume however that Carla’s lender uses an industry leading “solution” such as ITI and has never checked the default settings of the Installment Loan Accounting system. Instead of applying $1,275.30 to the outstanding balance, the system applies the payment “as of” the due date, September 1, 2010. Let’s now assume that Carla makes all of her remaining payments on the 15th day of each month or earlier and never misses a payment. The net effect of the misapplication of even a few payments can add up, depending upon the original loan amount, from several hundred to several thousand dollars over the life of the loan. This is interest the lender did NOT earn and, in fact, probably took from Carla in violation of the express terms of the Note and THAT’S a BANKING NO-NO!
The trouble with this scenario isn’t that it rarely happens (think more in terms of 25 – 33% of the time) or that it’s improper (it usually is), the problem is that very few consumers or their attorneys know that this practice is ongoing and the result of Lender negligence and disregard for the language contained in the contracts Lenders draft. Many, if not most installment loan Notes, specify that payments are to be applied “as of” the date of receipt. This, in effect, rewards the diligent payer and penalizes the tardy payer. Perfectly acceptable if the payer is aware of what’s happening. The question then is – what’s a consumer attorney to do? The answer is fairly simple, albeit not easy the first time.
To begin, you’ll need a copy of the installment loan Note signed by the borrower. Second, you’ll need a complete loan history for the loan showing every detail as to each payment received and applied by the Lender. Third, you’ll need to develop a method for doing a chain calculation such as a spreadsheet with a manually created formula. You’ll then need to input the data as it SHOULD have been reflected in the loan accounting system. This means you’ll need to identify the date EACH payment was actually received. If the Note states that every payment will be applied as of the date it is received then you’ll need to calculate the number of days between one date and another. If your software or other solution does not allow you to subtract an actual date from another date then you should count the number of days (if you try to use subtraction then you must always remember to ADD 1 when dealing with accounting systems, serially numbered items or dates because Subtraction and Counting are not the same mathematical function). Lastly, you’ll need to track the additional principal payments that should have been made and the unearned interest the Lender paid itself.
If the Note is silent as to WHEN payments are to be applied (i.e. as of the date of receipt versus the due date) then you’ll need to check your jurisdiction’s rules on the subject, if it has any. If the Note states that payments are applied as of the due date then tell your client to save his or her money and make their payments towards the end of the Grace Period. Paying a Lender on the Due Date in such a case benefits only one party – the Lender. There are, of course, factors that can and will result in changes in your calculations. Most consumers don’t pay their installment loans on exactly the same date each month or the same number of days before the due date and, instead, tend to make payments within a range of dates. Sometimes they may have actually made a payment “Late” (Late Fees and Reg. AA are topics for another day) and, depending upon the loan accounting system parameters even less of the payment will be applied to principal. However all of this pales in comparison to the gross (and often conscious) mistakes made by Lenders when a borrower seeks Chapter 13 Bankruptcy protection.
Ordinarily, when a loan is 90 or more days past due, either manually or automatically, it is placed on a “non-accrual” basis. The reason for this, at least as to any federally insured institution, is that the likelihood the loan will be charged off increases dramatically when a loan becomes 90 or more days delinquent. Despite this longstanding practice, Lenders seem to forget all about this virtual requirement when it comes to a borrower who has filed a Chapter 13 petition. While it is typically the case a Chapter 13 borrower/debtor is delinquent in some fashion, it may not be the case that they are 90 days past due. Keeping in mind the formula we followed above, consider that interest has accrued on the loan since the last payment made. If that payment was received 45, 60 or 90 days ago, then it is all but certain a regularly scheduled payment will not reduce the outstanding principal balance. In fact, once a borrower has gone significantly past due, if he or she fails to “catch up,” then it is not only possible but probable no regular payment will ever result in a credit to principal. In fact, it is likely the case that the “accrued interest” will continue to grow. Had the Lender placed the loan on a non-accrual basis then this problem would not exist. The Lender’s problem is the result of two basic failures. First, because the Lender has not placed the loan on a non-accrual basis, interest continues to accrue and the amount of interest due and payable has typically increased to the point it is substantially more than any installment payment. Second, because in a Chapter 13, all prospective payments made pursuant to the terms of the bankruptcy plan should be applied “as of” the date they are due and are not, the Lender both violates the Bankruptcy Code AND creates a potential accounting nightmare for itself.
What the Lender should do to deal with the problem is place the loan on non-accrual and begin calculating accrued interest from the date required by the debtor/borrower’s plan and the Bankruptcy Code. The arrearages, if any, are payable over the life of the plan. Due to the fact most loan accounting systems were developed in or prior to the 1980s, they simply don’t have the ability to both keep track of arrearages and properly calculate interest with the debtor/borrower’s plan and the Bankruptcy Code in mind. The ONLY solution is to perform the calculations manually. In the early 1980s this was not particularly difficult because loan accounting and servicing were often performed at small offices staffed by highly trained individuals. Using a calculator and appropriate records, the individuals charged with performing loan accounting (such as the now extinct “Note Teller”) would calculate the appropriate amount of interest accrued and then pass appropriate entries into their loan accounting and/or general ledger systems. Today few Lender employees are trained to manually perform such calculations and, as a result, Lenders have apparently chosen to “take the chance” the debtor/borrower will never question payment applications during the pendency of a chapter 13 bankruptcy. In light of the foregoing, the danger of this approach for a Lender should be quite obvious. Keeping in mind that “simple interest” is not added to the outstanding loan balance one should be able to calculate the proper application of post-petition payments from a chapter 13 debtor/borrower utilizing the formula discussed earlier. It is all but certain this is something the Lender is not doing.
It is hoped this discussion has benefitted the reader and helped him or her identify and understand ways in which Lenders fail to properly apply payments to simple interest loans and, unsurprisingly, help themselves in the process. Hopefully the information provided in thi article will assist you in helping your consumer clients as they are increasingly victimized by financial institutions that care only for profits and nothing for people. !
*Mr. Hackett is a Consumer Attorney and Recovering Banker.