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Consumer Credit Regulation: 5.3.6.3 Amortizing Variable Rate Loans over Fixed Time Periods

In many ways, amortizing a variable rate loan is similar to the amortization calculation in a regular interest-bearing loan.99 Each month (or other payment period), the current interest rate must be applied to the currently outstanding loan balance to determine the interest that has accrued. This accrued interest is deducted from the borrower’s payment, and the remainder of the payment, if any, is used to pay down the loan balance.

Consumer Credit Regulation: 5.3.6.4.1 Caps and floors on variable rates

A loan with an unlimited variable rate can be quite risky for a borrower, especially if it is a large mortgage loan that consumes a high percentage of the borrower’s income. Relatively small increases in the interest rate can significantly raise the monthly payment, and larger rate increases can force borrowers into default.

Consumer Credit Regulation: 5.3.6.4.2 Payment caps and their relationship to adjustable rates

Caps are essentially contractual limitations on the extent that the interest rate or the payments may vary during the loan term. They can provide borrowers with valuable safeguards against major fluctuations in market interest rates. However, all caps are not alike, and some may provide borrowers with little or no real protection. It is critical for attorneys who are reviewing proposed variable rate contracts to examine carefully the contractual language that defines the cap.

Consumer Credit Regulation: 5.4.2 Calculation and Accuracy of the Annual Percentage Rate

As suggested in the preceding subsection, the APR is basically an actuarial rate that states the cost of credit as a yearly percentage rate. However, Regulation Z, which implements TILA139 allows the APR to be calculated either on a strict actuarial basis, or through the use of the “United States Rule” (U.S. Rule).140 The two methods are similar in that each requires the application of an interest rate to an unpaid balance to produce the interest accrued during each payment period.

Consumer Credit Regulation: 5.5.1.1 When Does Compounding Occur?

Most attorneys are probably familiar with the concept of compound interest. In essence, compounding is the practice of charging interest on interest, or in other words, of adding accrued interest to the principal amount of a debt and making subsequent interest calculations on the basis of this new, increased principal amount. The effect of compounding is to increase the effective interest rate paid and the amount of interest earned on the debt.

Consumer Credit Regulation: 5.5.1.2.1 Whether state law prohibits compounding

The law traditionally has taken a dim view of the compounding of interest.167 The courts have recognized that compounding increases the yield that a creditor receives, and have questioned the use of compounding even when the ultimate yield that it provides is below the usury ceiling.168 The basic concern seems to be that compounding is deceptive, so that “an improvident debtor is not likely to realize the extent to which the interest will accumulate.”169

Consumer Credit Regulation: 5.5.1.2.2 Framing compounding as a usury violation

Although contract law arguments against the imposition of compound interest are worth considering in many consumer transactions, they have one major drawback. Specifically, the remedy for an impermissible agreement to compound interest may be limited to the voiding of the improper contract clause.176 Thus, whenever possible, it is to a consumer’s advantage to argue that compounding is prohibited not only by contract law, but also by a usury statute which contains more expansive remedies.

Consumer Credit Regulation: 5.5.2.1 General

Most of the discussion thus far of installment interest methods and calculations has rested on the assumption that in any particular transaction all of the payment periods are equal191 and all of the payment amounts are also equal.192 This assumption holds true for most consumer credit installment transactions.

Consumer Credit Regulation: 5.5.2.2 Weekly, Bi-Weekly Payment Periods; Legal Issues

The most common regular repayment period in consumer transactions is monthly. However, other periods are sometimes used. Used car financing contracts, for example, may call for weekly, bi-weekly, or semi-monthly repayment periods. Absent some specific prohibition, such shorter periods are legitimate. However, practitioners have found that it is relatively common for the dealer to run afoul of usury laws or TILA (or both) in doing so.

Consumer Credit Regulation: 5.5.3 Date Finance Charge Can Begin to Accrue

Another calculation issue is the date on which the creditor is allowed to start charging interest. In many credit transactions, there is a delay between the time the consumer becomes obliged on the contract and the time the creditor actually parts with the loan funds or the item being sold. Can the creditor begin charging interest on the date the contract is signed, or only upon disbursement of the funds or delivery of the goods?

Consumer Credit Regulation: 5.5.4.1 General

Lenders with interest-bearing accounts sometimes choose to ignore (within certain limits) the exact date a payment is made. If a consumer makes a payment a few days before the payment due date or a few days after the payment due date, the lender may nonetheless charge interest as if the payment were made exactly when due.214 Many mortgage lenders, for example, follow this practice, which benefits consumer borrowers who make their payments a few days late.

Consumer Credit Regulation: 6.6.2.1 General

In most circumstances, the statutory foundation for a claim for an excessive credit insurance charge is found in the credit statute applicable to the credit transaction in question rather than in the credit insurance code.

Consumer Credit Regulation: 7.7.3.1 Continuation of Taint in Renewal Transactions

Because consumer debt is frequently refinanced, it is important to consider the extent to which the presence of usury in one obligation affects the validity of a subsequent agreement between the same parties when they renew or extend the outstanding debt. The question is particularly significant when the new agreement calls for interest at a legal rate and would be valid but for the previous usury.

Consumer Credit Regulation: 5.5.4.2 365-Day Method

The most obvious solution to these issues is to divide the relevant annual interest rate by 365 (the number of days in a year)218 and then simply to count the exact number of days that have elapsed in each period.

Consumer Credit Regulation: 5.5.4.3 360-Day Method

Another method, that many creditors prefer because it is easier to apply, is to divide the annual interest rate by 360 and to assume that all monthly periods have thirty days. This assumption is maintained regardless of whether the actual number of days in a monthly period is 28, 29, 30 or 31.

Consumer Credit Regulation: 5.5.4.4 365/360-Day Method: “The Bankers’ Year”

A third method, the 365/360-day method, however, not only combines aspects of the first two methods but consistently generates interest higher than that produced by the other methods. The 365/360 method uses a 360-day year to calculate the daily interest rate, so that each day earns more interest. However, it also uses a 365-day year to count the number of days in any given payment period; it does not assume that each monthly payment period has thirty days, regardless of the actual number of days in a particular payment period.

Consumer Credit Regulation: 5.5.4.5 Effect of Late Posting of Payments

If the lender intentionally delays posting the payments, more interest may accrue over the term of the loan than contracted for or allowed by law. For example, assume a $1,000 simple interest loan made on April 1, with a monthly payment of $86.99 at 8%. See loan in Chart 6, supra. Assume that the lender calculates interest on a 365-day year, so the daily rate is 0.0219%. If the borrower pays the scheduled amount of $86.99 on time each month but the lender fails to post the payment for 15 additional days, the interest charges would look like this:

Consumer Credit Regulation: 5.5.5 Rounding

Attorneys calculating interest rates and payments will inevitably encounter the issue of rounding. Specifically, rounding is necessary whenever the product of a multiplication operation or the quotient (i.e., the result) of a division operation cannot be expressed precisely within some specified number of decimal places.

Consumer Credit Regulation: 5.5.6.1 A Calculation Defense to Usury Claims in Fixed Term Loans

The rate of interest charged on many loans fluctuates during the term of the credit. This fluctuation may be obvious, as in the case of loans in which the interest rates are pegged to some market rate such as the federal discount rate, or it may be concealed, as in the case of apparent fixed rate loans in which the borrower must pay various one-time fees at the outset of the transaction as well as the constant monthly payments.255 In either situation, a tricky usury issue may arise.

Consumer Credit Regulation: 5.5.6.3 Spreading in Special Situations

A final issue raised by the concept of spreading is the term over which interest payments may be spread. This issue can arise in two basic situations: when the term of the credit is shortened, usually by default or prepayment; and when there is more than one credit transaction between the same debtor and creditor.