It's All in the Payment - Part II

We've been away for a while without a new blog post waiting for the launch of the new Carleton, Inc. website which will be the new home of the Carleton Compliance Blog.  Like any undertaking of that magnitude, it is taking a bit longer than originally planned but we're almost there.

 Meanwhile, subjects, issues, and opinions have been piling up, so it' time to get back on track talking about consumer credit calculation compliance.

In May of this year we discussed how all the components of a credit transaction are included in the computed payment amount.  You just have to know which perspective to view things from to see them.

Now, rather than look at components included in the payment amount, we want to examine the nominal payment amount itself.  One characteristic of simple interest (aka "interest bearing", "per diem", "daily interest") consumer credit transactions is that the regularly scheduled payment amount is often viewed as rather arbitrary in nature.  

Since there is a good chance the consumer will not make each and every payment exactly on the scheduled due date, even though electronic debit technology is starting to challenge that thought, the actual interest accrual and outstanding principal balance profile will not match the scheduled amounts anyway.  So, the computed/disclosed regular payment amount is arbitrary in nature and the final payment amount will reflect it along with the potentially nebulous paying habits of the consumer.

Well, there is a dose of truth and reality in that thought.  However, from the perspective of  a service provider whose point of concentration is the computed disclosures, we realize that you can't logically program "arbitrary".

By that, we mean the regular payment amount has to be based on some criteria.  We choose to do the following in our computing routines:

• The regular payment amount is the full  precision amortizing payment for the balance and rate computed on the assumption that all payments are made and posted on scheduled payment dates.  If you took that full precision payment and posted payments on the schedule due dates, the final balance would be zero at maturity.
• The regular payment is then high rounded to ensure the computed odd final payment will not exceed the amount of the regular payment.
• The process of "high penny rounding" the payment also minimizes the difference between he regular payment and the computed odd final payment.

Twenty years ago the code to  find an actual day interest, simple interest payment was cumbersome and slow.  Today's increased computing power and processing speeds have made those past concerns and constraints a moot point.  However, we still regularly encounter systems that take a formula approach to computing the regular payment.

Since there is no precise formulaic solution to computing a payment accruing interest on an actual calendar day basis, these approaches produce payment amounts that are not precisely the amortizing payment amount. The only accurate way to arrive at the accurate amortizing payment is through the process of amortization.

Sometimes, the difference between the amortizing payment and the formula payment is slight, say two to three cents, and sometimes it is more significant, somewhere in the neighborhood of eight to twelve cents.  However,  the effect of even the larger difference can be mitigated by the process to arrive at the remaining disclosure numbers.

By that I mean as long as the regular payment amount is set and an accurate process of amortization on an actual day calendar basis interest accrual is used to arrive at final last payment, the results are accurate and compliant.  The amortization process to arrive at the final payment ensures that the effective contract rate is maintained.

For example, $9,000.00 principal, 12% simple interest, 60 payments
Date of Contract 08/15/12
Date of 1st Pmt  09/15/12

A - Amortizing Payment
Accurate amortizing payment: $200.188749 or $200.19
Final payment amount: $200.05

B- Formula Payment
Formula payment: $200.27
Final payment: $193.63

When actual calendar days accrue interest and the rate for each day is 1/365 in a  normal year and 1/366 in a leap year, both transactions amortize to a zero balance at scheduled maturity.

Example A produces $1.70 more in total interest charge.  The larger payment in the formula approach liquidates the principal just a bit faster and, thus, produces slightly less of a charge.

The key here is that both payment schedules amortize the debt to a  zero balance at maturity and maintain the effective interest rate of 12% simple interest.

With "simple interest" (aka interest bearing) loans it is difficult to make a case for a 'right payment' amount.  Unlike precomputed loans where the interest each period is pre-determined, the simple interest approach lends itself to potential fluctuations from scheduled amounts based on the paying history of the borrower.

Carleton would employ method A as a default.  We like to be able to explain exactly how the payment we disclose was crafted and what rules were employed during the calculation.  We believe that's part of accurately portraying the contractual obligation.

Consumer credit mathematical routines are so complex that one significant drawback to a "formula" approach is that it is open to the interpretation of the creator.  Many choices and decisions are made while employing the formula and chances are very good that only the original developer/programmer who created it knows what those specific points are.  So duplication is often an issue if the creator isn't around to be involved in later retro-fitting.

This is an instance where the payment amounts for the two approaches do not need to be identical for the transaction disclosures to be accurate, valid, and compliant.  The path to the destination may take different routes, but the end result is the same.