"Suppose the interest rate on the loan is 6%. The lender pretends there are 360 days in a year when calculating the daily interest rate (6% / 360 > 6% / 365), then charges interest on 365 days (366 during a leap year). In using the 365/360 method on a loan with a rate of 6%, the lender will actually be charging an annual rate of 6.083% (.06 / 360 x 365)." Source
However, the lender will only quote the borrower that the rate is 6%. It is the method of interest payment calculations that will cause the consumer to pay more in interest under the 365/360 calculation method than the standard 360/360 interest calculation method. This means a consumer looking at two interest rate offers of 6% may not recognize that there are other factors that would affect their cost for the loan.
The government currently requires that all lenders disclose how much the consumer would pay in interest and fees over the life of the loan in the form of an APR %. The APR is calculated by taking the total cost of the loan (interest expense regardless of calculation method + loan closing costs) and reverse engineering it into an interest rate. Therefore, technically, the borrower will know that he is paying more in something if he were to compare the APR of two lenders who is offering the same 6% rate.
Typically, lenders who perform these actions won't disclose their method of calculating interest until closing. This leaves the borrower limited time to change their mind.
I'm curious to know how one would unpack the virtue of honesty and apply it in this scenario.
The legal discussion linked in the question (first paragraph, under "Source") is interesting and good advice for borrowers. As long as borrowers have the opportunity to find out in advance which method a lender uses (if the borrower cares about it), I don't see a big moral issue. Lenders should be free to set whatever lending terms they wish, and borrowers should be free to accept or reject the terms in advance of accepting the loan. The interest calculation method used by the lender generally should be stated explicitly somewhere in the loan documents, or else the courts may interpret the method in accord with generally accepted standards in the financial industry and the wider community if a dispute arises that is adjudicated in a court of law.
Borrowers should also be well aware that a "6%" interest rate almost never means that the interest paid each year will be exactly 6% of the remaining loan amount existing at the beginning of the year. There is usually daily compounding of daily interest to consider, and also the fact that part of each payment due on the loan usually goes toward the principal as well as what goes toward interest. Mathematically, daily loan balance continually increases due to accumulated interest, and periodic reductions occur in the remaining loan balance due to payments made by the borrower. Both factors have a big effect on the actual amount of interest that the borrower needs to pay each year for the duration of the loan. If the exact details are important to a borrower, and the borrower is willing to compute it for himself using a spreadsheet or other means, the borrower should inquire about it before signing up for the loan, and may want to consider rejecting the loan entirely (before signing) if the borrower doesn't receive satisfactory answers from the lender.
In my own experience, I have found that the exact calculations are often very difficult to understand in advance, but become completely clear and reasonable after the first one or more monthly statements showing how much of each payment went for interest and how much went toward the principal, compared to the "nominal annual rate" stated in the loan documents. Basically, the lender typically divides the nominal annual rate by 360 or 365 to get the daily rate, then applies interest accumulation on a daily basis according to the remaining loan balance on each day. It should also be noted that even 365 isn't exact, since some years have 366 days. As far as I know, loans of this kind normally don't try to allow for 366 days instead of 365. They simply divide by 365 (or 360) even in years that actually have 366 days, and then apply that daily rate each day throughout each year.
The reference linked in the question tries to make a moral issue out of a Wisconsin law stating that lenders are legally permitted to use 360 instead of 365:
[Wisconsin law cited by Willich Law Office, LLC] 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.
While it is usually not good for lenders to obtain special privileges or subsidies from the government, in this case the government is only reinforcing the freedom that lenders should have to set their own loan terms (with opportunity for borrowers to inquire about it and accept or reject the loan in advance of signing up for it if the borrowers don't like the answers they receive). So the result in this case is the same as if the motivations of the parties had been more explicitly pro-free-market, more openly affirming the morality of rationality and individualism.
answered Apr 09 '14 at 21:03
Ideas for Life ♦