I know this sounds silly, but I am new to compliance, directly out of quality control. Unlike compliance, some of the terminology in QC we don't use enough to allow me to become familiar. Out of curiosity what is the difference between a Pre-Computed Interest Loan versus a Simple Interest Loan? Thanks!

Simple interest is computed on the actual balance outstanding on the payment due date. Precomputed interest is calculated on the original principal balance. The interest is added to the original principal balance and divided by the number of payments to determine the payment amount. In some cases, the original balance is discounted and interest is earned on the interest. Often, in the past, precomputed interest was taken into income on an accelerated basis, such as the Rule of 78s; however, the Rule of 78s is no longer an acceptable method of accounting for loan income. The acceptable method for accounting for loan income is the actuarial method. Basically precomputed interest is an old usury busting technique that very few lenders use today.

Simple Versus Precomputed Interest -Examples
8% SIMPLE INTEREST 8% ADD-ON INTEREST
Amount Financed 5,000.00 5,000.00
Finance Charge 640.48 1,199.92
Total of Payments5,640.48 6,199.92
APR 8.00% 14.55%
Payments 36 x 156.68 36 x 172.22

Jack - I have to take issue with your example. I had a lot of experience with Rule of 78 loans, and here is my question. Assuming no prepayments on a loan, there is no difference between Rule of 78 and Simple interest. If you financed $5000 at 8% for 48 months, you would get the same payment and the same total of payments looking at the original amortization schedule. The difference comes when someone makes prepayments or additional princ. reductions. I guess I am confused as to your example.

The rule of '78 came out came out to 8% - the same as simple.

For the Add-on, the finance charge would be $5,000 X 8% x 3 (years) that is = $1200. The total loan would be $6200 and for 36 months it would be $172.22 payment.

Discount would be even worse.

The difference comes in when the bank earns the interest each month. The monthly interest on rule of 78's is much higher than the corresponding simple interest (or the interest using the actuarial formula). This is true for the first half of the loan or so. Then the monthly interest is more for simple on the back end -- but by that time the customer has already 'paid the premium'. A customer who made each and every payment on-time would have the same net effect over the life of the loan either way, but if they ever paid off early they would pay more interest.

The other cosideration with pre-computed vs simple interest loans is that the interest is usually earned in monthly amounts on pre-computed loans vs. daily amounts on simple. To me, that also causes the customer to over-pay interest unless each and every payment were paid exactly on the due date for the exact payment amount.

HELP!
Is there a law or regulation which specifies when a bank CANNOT use precompute?

Here is what our policy says, "Any loan with a term in excess of 60 months must be made on a simple interest basis. This would include a loan of 60 months, which has a first payment date greater than 30 days from date of advance."

I looked into state law and was told by counsel that it did not apply. Is there a federal rule or perhaps some guidance that I do not know about?

I can't put my finger on it just this minute. But the deal is, the IRS wants the bank to be taxed on earnings based on a simple interest accrual. This basically forced banks to go to simple interest accrual, from the Rule of 78s. If you earn on 78s, you'd have to reamortize everything for earnings purposes, as I recall.

(See what you did. Now my brain hurts.)

Thank you thank you thank you Andy.

Now...my brain hurts...I need to make sure we're not screwing this up.

You got the core of it, Andy. It's a "Revenue Ruling" dating back to 1983. Go here for the ruling.

Unfortunately, I'm resuscitating this topic. I apologize in advance. Does using the "actuarial method" for computing interest imply a precomputed loan? This is a rebate method?

If this is the case, and it is precomputed, is the rebate based off the original schedule of interest? Is the interest earned on the first day of the payment or prorated based on the number of days left in the payment period? Ignoring other fees (like late fees), is the contract amount (original schedule) the most a lender can collect from the borrower for this loan product?

I don't tie the acturarial method to precomputed interest. I tie the Rule of 78's to precomputed interest.

Nick- Add-on lending requires totally different accounting methods from simple interest. To tell the difference, look at the amount you debit to your G/L "Loans" account when you book a new closed-end loan. If it is the principal amount of the loan, then you are doing simple interest. If it is the total of payments of the new loan, then you are doing add-on. If it's add-on, you will also book as a liability all of the projected interest. This accrual account is usually called "unearned discount" or something of that kind.

Richard, for add on lending, how is the unearned interest calculated when the borrower pays early (or off completely), if the projected interest is based on the original schedule of payments? This seems like a precomputed loan w/ a different rebate method than rule of 78ths?

@Andy - thanks for the clarification.

Hi Andy, I'm getting some conflicted information from the Federal Reserve regarding the actuarial method. This is from the Federal Reserve's website: "The Constant Yield (Actuarial) method is similar to the Simple Interest method except that to pay off the loan early, you may have to pay the full remaining principal and interest (which is precomputed.) The lender should then refund the unearned interest to you. (In some cases, the lender may deduct the unearned interest from the amount you owe to reduce the amount you must pay.)"

I read this as precomputed, but the terminology may be generic for all I know. I'd love to get your opinion.

http://www.federalreserve.gov/pubs/leasing/resource/different/early_exp5.htm

The note will have to specify the method. Historically, most add-on lenders used the Rule of 78 because many state laws required it.

The Rule of 78 determines the amount of interest the lender has earned at any point in a loan--based on the number of months elapsed/remaining, NOT the number of actual payments received from the borrower. A payoff calculation was simple: multiply a factor (from a sum-of-the-digits table) times the total LOL interest, add the original principal amount, and deduct the sum of all payments received from the borrower. (Adjustments were needed when fees, credit insurance premiums, and other non-principal-or-interest amounts were included in the payment schedule.)


It may be easier for us to help you find the appropriate information if you would give us the context in which your questions arise. The linked material from the Fed attempts to compare financing methods with consumer leasing alternatives. If memory serves, this material is drawn from a paper publication by one of the Reserve Banks in the late '70s. That would mean the discussions relates to lending practices of that era. Several things have changed since then.

In response to record high interest rates in the early '80s, consumer lenders introduced variable rate (non-mortgage) consumer loans. Since it is impossible to use the Rule of 78 to account for interest in a VR transaction, lenders were forced to implement some form of simple interest accounting. Once that mechanism was in place, lenders could easily switch fixed rate loans to that accounting method.

The other major development (mentioned above), was IRS Rev. Proc. 84-27. For loans with terms > 5 years, this ruling provided that the Rule of 78 method for computing interest income was generally prohibited from being considered an acceptable accounting method. Since big ticket purchases were financed over longer terms, lenders were forced to adopt some form of simple interest accounting.

The combined effects of regulatory and market forces caused many lenders to abandon all forms of precomputed consumer lending.

Richard, here is some context, we have a new consumer installment law in Illinois. This is for small lenders. The new language was hacked together by the legislation and the Dept. of Financial Institutions has not established any rules regarding the new law. Here is the part of the act that confuses us:

"For purposes of determining the finance charge earned on an installment loan, the disclosed annual percentage rate shall be applied to the principal balances outstanding from time to time until the loan is paid in full or until the maturity date, which ever occurs first. No finance charge may be imposed after the final scheduled maturity date. When any loan contract is paid in full, the licensee shall refund any unearned finance charge. The unearned finance charge that is refunded shall be calculated based on a method that is at least as favorable to the consumer as the actuarial method, as defined by the federal Truth in Lending Act. The sum of the digits or rule of 78ths method of calculating prepaid interest refunds is prohibited."

There are two issues here: 1) Calculating interest using an APR? Does not make sense to me. An APR is a disclosure. It does not determine how interest is added to a loan. Not to mention that the APR and interest rate are typically different for an installment loan when using the actuarial method for calculating an APR. 2) When the borrower pays early, how do you handle the prepayment? We accrue interest daily, using the simple interest method (DSI - daily simple interest). My concern is that if a customer is late on scheduled payments and then pays off prior to the maturity date, using the same methodology as the DSI to calculate the payoff will not be as favorable as the actuarial method (or the rule of 78ths method for that matter). Ideally, we would like to refund/rebate the interest in the same manner that it was earned, but do not want to over charge the borrower under the letter of the law. Finally, is there any unearned interest using DIA method. Like you said above, the receivable start as the principal balance on day one. I don't make the correlation between the TOP on a closed ended product.

You are right about the APR vs interest rate and AF vs. principal amount. The APR and AF are disclosures, not contract terms. If your state law paired the APR with the AF, this would be workable.

Clearly, the legislature's intent was to prohibit add-on interest methods and Rule of 78 rebates. You are doing neither. By using DSI, you are most likely doing exactly what your legislature had in mind. If you can get your DFI to issue a regulation or letter ruling to that effect, you should be OK. If DFI won't or can't issue such a ruling, you have an unmanageable risk.

Thank you very much Richard. We just have to use our method and be prepared to back it up. As a side note, does TIL require the interest accrual method (or interest rate for that matter) be disclosed on the promissory note?

Also, I'm confused about this part of your statement(see below). The reason I ask is that we will have some input on how the DFI creates the rules regarding the new statute. My only solution, up to this point, was to change the "Annual Percentage Rate) language to read "interest rate".

TIL doesn't govern the content of your notes at all. Case law of your state is where the rubber meets the road & notes contain the language necessary to assure that the lender will prevail if the note has to be enforced in court.

As you pointed out earlier, the IR and LA relate to one another as do the APR and AF. You can't combine a TIL disclosure value with a contract term and calculate anything meaningful. Your best bet with DFI is to get the agency to issue one or more examples of cradle to grave numbers that would comply with the new statute. Sometimes, it's easier to see the point using the numbers instead of a description of the processes that produce the numbers.

Hi Steven, can you explain the difference between simple interest and the actuarial formula? Simple interest is pretty straight forward, but there is not a lot of data on the actuarial method. If you have a resource to add, I'll take it.

Thank you,