August 2, 2018

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.