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Daily Interest: A Festering Sore in
Consumer Loan Markets

*
Question:* What do home mortgage loans
including second mortgage loans, retail installment loans,
automobile loans, home improvement loans, and mobile home
loans have in common – aside from being loans to consumers?

*Answer:* The interest charge
sometimes is calculated monthly and sometimes daily. With a
monthly interest rate (MIR), the borrower is charged for
each month whereas with a daily interest rate (DIR) the
borrower is charged for each day.

Why is this distinction important? Because DIRs are
a potential trap for unwary borrowers, countless numbers of
whom have found themselves permanently indebted, usually
with no understanding of how it happened. The problem has
been entirely overlooked by regulators, including the
Consumer Financial Protection Bureau.

*An Example:* Consider a 30-year
loan for $100,000 with a rate of 6%. The monthly payment for
both a MIR and a DIR would be $599.56, part of which pays
the monthly interest charge, with the remainder
allocated to principal. To calculate the interest charge on
an MIR, the annual interest rate is divided by 12, then
multiplied by the balance at the end of the preceding month
to obtain the interest due for the month. If the loan
balance on the 6% MIR is $100,000, the interest due for the
month is .06/12x100, 000 = $500. The principal is 599.56 –
500 = 99.56.

With a DIR of the same amount and same annual rate,
the daily interest is .06/365x100,000 = $16.44. The interest
due for the month is 16.44x30 = $493.3 or 16.44x31 =
$509.64, resulting in principal of 106.56 or 89.92,
depending on whether the month has 30 or 31 days.

*Treatment of Late Payments:* The
payment due date is usually the first business day of the
month for both MIRs and DIRs. The critical difference
between them is their treatment of payments that are posted
after the due date. MIRs typically have a payment grace
period of 10 to 15 days during which the lender will accept
the monthly payment as payment in full. Borrowers are
subject to a late charge only if their payment is posted
after the grace period has expired.

On a DIR, daily interest accrual never stops. If
the borrower pays on the first day of a month following a
month that has 30 days, she owes 30 days of interest. If she
pays on the fifth day of the month, she will owe 34 days of
interest. But it also works in the other direction. If the
borrower pays before the due date, say on the 25^{th}
day of the preceding month, she will owe only 25 days of
interest.

It follows that DIRs are much more challenging for
borrowers than MIRs. Disciplined borrowers who understand
how it works can sometimes use it to their advantage, but
they are very few. Most borrowers who have DIRs do not know
it, and their ignorance often costs them dearly. Many of
those with less-than-pristine payment habits find themselves
on a slippery slope toward permanent indebtedness.

*The Slippery Slope of a DIR: *
Consider the DIR referred to earlier with an annual rate of
6%, a mortgage payment of $599.56, daily interest of $16.44
and total interest due for a month with 31 days of $509.64.
If the borrower pays on the due date, her payment to
principal will be 599.56 – 509.64 = 89.92. But for each day
she is late, the interest charge rises and the payment to
principal declines by $16.44. If she is 6 or more days late,
the interest charge exceeds her monthly payment, so instead
of a payment to principal, the lender records an “interest
deficit”.

The borrower is now on the slippery slope because
the interest deficit is added to the interest charge due the
following month. So long as the borrower has an interest
deficit, the loan balance remains unchanged.

*The Slope is Steeper at Higher Rates:
*The higher the interest rate, the quicker is the
emergence of an interest deficit. At 3% the borrower has 20
days to avoid a deficit, at 6% she has 5 days, and at 12%
she has 1 day. The trap closes most quickly on the weakest
borrowers who pay the highest rates.

*DIRs Are Not Inherently Flawed:*
In a market where borrowers were offered both MIRs and DIRs,
and prospective borrowers understood the features of both,
those who could make payments at regular intervals shorter
than 30 days – every 28 days, for example -- would select
DIRs. Everyone else would select MIRS unless they were
enticed to accept DIRs in order to get a lower interest
rate. DIRs would be priced lower. But that is not the market
we have.

*Borrowers Have No Choice:* I
have never encountered a case where a borrower was offered
the choice of MIR or DIR. Invariably they accept what they
are offered, without realizing there is an issue. I have
encountered many cases where borrowers initially had an MIR,
which was switched to DIR by another lender after their
loans were sold. Such a switch must be permitted by the
note, which has been the case with every note I have
examined. Notes are silent on how the interest charge is
calculated.

*Misleading Documents: *Last week
I was approached by a lady who had purchased a manufactured
home in 1998 for $39,000 and financed it with a retail
installment contract at 12%. Her concern was the usual one
that arises with DIRs: after 20 years, she owed almost as
much as she had borrowed. No one had ever explained the
perils of daily interest to her.

The documents she was given at origination had only
one clue. On a document called “Type of Mortgage”
there was a checked box called “Simple Interest”. That
is the code name for a DIR. But the dictionary tells us that
simple interest means that interest is not paid on
interest. And it is true that on the DIR, interest is not
paid on the interest deficit. But almost all MIRs are
also simple interest. The only MIRs I know of that
permit interest compounding are the toxic option ARMs
that were written before the financial crisis but not since.
The only reason to describe a DIR as a simple interest
loan is to obfuscate its central feature.

The interest rate shown on the origination
documents is the annual rate, which is used in calculating
the monthly payment. But on a MIR the interest rate the
borrower actually pays is the daily rate, and that is not
shown. Showing the daily rate could give the game away.
Lurking in the shadows is the question of whether that rate
is calculated using a 365-day year or a 360-day year. There
is no way to know.

The servicing statements the borrower receives
perpetuate the obfuscation. They show the interest charges
that have accrued but not a clue as to how the charges are
calculated.

*Where Are the Federal Agencies? *
With one exception, they ignore the issue. The pricing
schedules and underwriting requirements of Fannie Mae and
Freddie Mac do not distinguish between mortgages charging
monthly interest and mortgages charging daily interest. The
agencies purchase both subject to the same requirements and
the same prices. This is difficult to rationalize because
the loss rates on DIRs are bound to be greater than those on
MIRs,

The Consumer Financial Protection Bureau (CFPB) was
created to protect consumers, with a major focus on loan
disclosures, which it took over from HUD and the Federal
Reserve. Redesigning the disclosure forms was a major
priority. Its new Loan Estimate designed for shoppers and
its Closing Disclosure for borrowers are larger and clearer
than the documents they replaced, but neither shows whether
interest is calculated daily or monthly. This is shameful.

I am told by reliable sources that FHA will not
insure a daily interest mortgage, so they are evidently the
exception, but I have not been able to confirm this.

Next week: How to fix this festering sore.