Contemplating the APR
2013 has begun with a deluge of questions, issues, and investigative queries from a diverse cross-section of lenders in the consumer finance industry about the specifics of proper APR computations.
The "devil" is in the details and the recent plethora of issues presented had indeed "drilled-down" to the very unique and peculiar properties of Appendix J to Regulation Z and the accompanying definitions of terms and concepts.
Remember that Appendix J was created to serve as the "how to" for APR calculation to fill a void left by the original Regulation Z that described the concept of the APR but left too much regarding the detail level nuts and bolts issues open to interpretation.
It was also formulated during the late 1970's when the vast majority of calculations were fairly generic and repayment was primarily monthly in nature. Those factors definitely influenced the viewpoint of the Consumer Affairs Committee in creating Appendix J.
Some random thoughts concerning the issues currently creating a buzz in the consumer finance industry:
- The APR isn't the interest rate. We've discussed this in previous blogs and it continues to be a prevalent issue. Keep in mind that nowhere in Appendix J or Reg. Z does it state that "if no fees are present, the APR will be considered accurate if it is the same value as the interest rate".
- If that is the case and accuracy is achieved by a simple eyeball test, why does Appendix J contain 16 pages of detailed definitions, variables, and algorithms? Since the majority of consumer lending transactions don't contain prepaid finance charge fees, what's the point?
- February really does throw a wrench into any logical view of how time periods should be measured. The edict to use the last day of February when payments are scheduled for the 29th or 30th of a month creates some interesting scenarios. If the contract date is January 29th and the first payment date is March 30th, how many whole unit periods does that produce by the Federal Calendar?
- The trend to tie repayment to the borrower's payroll cycle is causing a tremendous amount of "gnashing of teeth" in trying to make sense out of two payments scheduled per month within the context of a 365 day year, months that have 31 days, and a "most commonly occurring" time interval between events.
- Back to point No. 1 : If daily interest accrual (aka simple interest) produces a total interest charge of $55.08 for a twelve month loan without fees, and monthly interest accrual (aka unit period) produces a total interest charge of $54.92 for the same twelve month loan with no fees , shouldn't the APR be higher for daily accrual (10.02%) than for monthly accrual (10%)? Seems to me like Truth in Lending working as intended: larger finance charge, larger APR.
- Servicing systems that employ the practice of pulling the contract APR (Truth in Lending APR) into the core system to process payments should perform an evaluation of the parameters at the detail level. Those processes were probably put into place years ago when interest was computed monthly and was more closely associated with the APR calculation itself. Simple interest properties have changed that landscape enormously.
- The original intent of the Truth in Lending Act APR was to serve as a basis for consumers to compare the cost of competing financing transactions. The APR was not meant, nor designed, to measure the loan's profitability for the lender. The mathematics behind the calculation bear out that the APR is a great visual graphic but a poor indicator of individual loan profit. It is unfortunate that it gets used in that context so often when discussing regulation of the consumer finance industry.
Posted on Feb 12, 2013