Q&A: Here’s a question that a Wisconsin credit union recently asked The League’s Legal Affairs team, along with our answer. Do you have a compliance question? Contact The League’s Compliance Hotline at (800) 242-0833 or email.
Q. Can our credit union compute the simple interest rate on a residential mortgage loan by charging 1/360 (rather than 1/365) of the annual interest rate on each day in the year? We use The League’s Mortgage Note (Non-Consumer) #82042.
A. Some lenders seek to compute interest at 1/360 of the annual rate on each day rather than 1/365th. This yields somewhat more interest over the course of the year because the lender is charging 365/360 of the annual rate.
But the practice has legal and compliance risks. Because of those risks, basic notes such as The League’s Mortgage Note (Non-Consumer) #82042 are not designed for use with 365/360 interest. It is not commonly used on consumer or residential real estate loans. It is more common on business loans.
Here are the major compliance or legal issues we see with 365/360 interest computations.
The Loan Agreement
Borrowers sometimes sue when they find that they are being charged 1/360 interest each day on a loan, arguing that they are being overcharged. They are charged interest higher than the nominal rate that they have agreed to. It amounts to five extra days of interest in a year, six in a leap year.
Some states, including Wisconsin, have sought to defuse the situation. Ten years ago the state passed this provision, which applies to nearly all loans – consumer, business, real estate, – but not pawnbroker’s loans.
138.045 Method of calculating interest. Interest on any note, bond, or other instrument computed on the declining unpaid principal balance from time to time outstanding may be computed and charged on actual unpaid balances at 1/360 of the annual rate for the actual number of days outstanding if the use of this calculation method is disclosed in the note, bond, or other instrument.
This section does not apply to pawnbrokers’ loans under s. 138.10.
Please note that the statute permits 365/360 interest only if the loan note discloses that method. A borrower signing the note is agreeing to the terms disclosed, including any clause providing for the 365/360 day interest computation. Here’s an example from one bank’s loan note:
The annual interest rate for this Note is computed on a 365/360 basis; that is, by applying the ratio of the annual interest rate over a year of 360 days, multiplied by the outstanding principal balance, multiplied by the actual number of days the principal is outstanding.
Having an adequate 365/360 day interest clause in the note is an essential step. But it does not cover all of the risks. Please read on.
Truth in Lending Accuracy
Using 1/360 may sometimes result in a Truth in Lending violation due to discrepancies between how the figures in the disclosure are calculated as opposed to how the interest is actually charged on the loan. For years, the federal regulators have highlighted the issue. We provide the CFPB’s current guidance in full below:
CFPB – Interagency Consumer Laws and Regulations – Truth in Lending Examination Procedures
*****
4. 360-Day and 365-Day Years – 12 CFR 1026.17(c)(3)
Confusion often arises over whether to use the 360-day or 365-day year in computing interest, particularly when the finance charge is computed by applying a daily rate to an unpaid balance. Many single-payment loans or loans payable on demand are in this category. There are also loans in this category that call for periodic installment payments. Regulation Z does not require the use of one method of interest computation in preference to another (although state law may). It does, however, permit financial institutions to disregard the fact that months have different numbers of days when calculating and making disclosures. This means financial institutions may base their disclosures on calculation tools that assume all months have an equal number of days, even if their practice is to take account of the variations in months to collect interest.
For example, a financial institution may calculate disclosures using a financial calculator based on a 360-day year with 30-day months, when, in fact, it collects interest by applying a factor of 1/365 of the annual interest rate to actual days.
Disclosure violations may occur, however, when a financial institution applies a daily interest factor based on a 360-day year to the actual number of days between payments. In those situations, the financial institution must disclose the higher values of the finance charge, the APR, and the payment schedule resulting from this practice.
For example, a 12 percent simple interest rate divided by 360 days results in a daily rate of .033333 percent. If no charges are imposed except interest, and the amount financed is the same as the loan amount, applying the daily rate on a daily basis for a 365-day year on a $10,000 one-year, single-payment, unsecured loan results in an APR of 12.17 percent (0.033333 percent x 365 = 12.17 percent), and a finance charge of $1,216.67. There would be a violation if the APR were disclosed as 12 percent or if the finance charge were disclosed as $1,200 (12 percent x $10,000).
However, if there are no other charges except interest, the application of a 360-day year daily rate over 365 days on a regular loan would not result in an APR in excess of the one-eighth of one percentage point APR tolerance unless the nominal interest rate is greater than 9 percent. For irregular loans, with one-quarter of one percentage point APR tolerance, the nominal interest rate would have to be greater than 18 percent to exceed the tolerance.
NOTE: Notwithstanding the APR tolerance, a creditor’s disclosures must reflect the terms of the legal obligation between the parties (12 CFR 1026.17(c)(1)), and the APR must be determined in accordance with either the actuarial method or the U.S. Rule method (12 CFR 1026.22(a)(1)). A creditor may not ignore, for disclosure purposes, the effects of applying a 360-day year daily rate over 365 days (Comment 17(c)(3)-1.ii).
Misleading Practices; Misleading Advertising
Some of the legal challenges against lenders assert that it is misleading for loan officers or advertisements to state the interest rate without pointing out when the 365/360 computation would be used. Those claims sometimes succeed even when the note states the details of the interest calculation method, and the Truth in Lending disclosures are accurate. The California Supreme Court took the following position in a case against Bank of America.
As commonly understood, a year has either 365 or 366 days. (Id.) In the absence of evidence to the contrary, we must assume that the public is likely to understand that a “per annum” rate is an annual rate based on a 365-day calendar year. The fact that it may be “customary” business practice within the banking community to quote interest rates on the basis of a 360-day year does not necessarily establish that the practice is not misleading to the general public with whom defendant deals. Moreover, the fact that defendant may ultimately disclose the actual rate of interest in its Truth in Lending Statement does not excuse defendant’s practice of quoting a lower rate in its initial dealings with potential customers. The original, lower rate may unfairly entice persons to commence loan negotiations with defendant in the expectation of obtaining that rate. Defendant offers no sound reason why it could not quote an accurate annual rate during its initial communication with its customers, rather than withhold such information until the customer has entered its premises.
– – Chern v. Bank of America
Conclusion
In the end, a credit union seeking to compute interest using the 365/360 interest calculation must be sure that its loan note, any Truth in Lending disclosures, its APR calculation tools, data processing, advertising, and loan quotes are all consistent in properly addressing the interest calculation.