Hi,
For those who may not know me. My name is Michael Gruber. Once president of the VFA, and co-producer of a product called LoanAlert. LoanAlert is a Windows base software application designed for vendor-financiers to allow them to create consumer credit code compilant loan statements.
However, one feature that has been missing is the ability to manage interest only loans, at present, LoanAlert can only manage principal and interest loans.
I’ve decided to write this post, because I wish to solicit information from vendor financiers and to ask them direct, “how do you manage interest only loans?”.
The answers I obtain will assist me with the practicality of developing such a feature.
The truth at the moment is, yes an interest only feature is possible, but would not be useful to many (if not any) people.
Let me explain my viewpoint, so you can understand the issue I have with interest only loans.
Please bear with me, this is a long post because it will go into the mechanics of lending in a little detail.
Principal & Interest:
The most common form of loans are principal and interest loans. Where payments are determine so that each one pays a portion of interest and an amount off the original loan balance so that after a period of time, the loan is paid in full.
The method by which payments are calculated is called amortisation, amortise meaning to reduce by equal amounts. In theory, as the loan balance (principal) is reduced, so does the amount of interest charge, so that towards the end a larger % of each payment is paying off the principal.
The easiest way to determine a loan payment is using Microsoft Excel’s PMT formula.
Now, having said all that, we need a system to actually determine how these payments are affecting the loan balance on a daily basis.
This is actually very simple…
First we determine the interest rate for each day, we do this by dividing the annual interest rate by the number of days each year, e.g 365.
Next we need to determine the “actual” daily balance. This is also straight forward, we take end of day (EOD) balance of the day before, add any interest (that has acculmulated) as well as any fees and deduct any payments made on the day. We are then left with the current daily balance. We then multiple this with the daily interest charge. The result of which is the interest calculated for that day.
Now, most loan contracts will state, “interest calculated daily, compounded monthly”, this means that the daily interest, which is calculated each day, is actually only applied (added) to the loan balance once a calendar month. In some cases (and in the case with LoanAlert) the daily interest is applied is the same date the loan began. So if the date of draw down was the 5th of Jan 2006, then interest will be applied on the 5th of each month.
To work out how much interest should be applied, we add up all the daily interest charges calculated since the last time interest was applied and then add this sum total of the “monthly anniversy” of the loan.
So in effect if a borrower were to pay weekly, what would happen is the loan balance would drop each week as payments are made then once a month the balance would jump up as interest is applied. However the balance will be smaller than the last time interest was applied because some of the principal is being nibbled away by the payments so the interest the following month will be slightly smaller.
The great thing about this system, is that it is perfectly balanced, by this we mean, if the borrower makes larger payments, they pay less interest, if they go into arrears they get charged more interest, because the system calculates interest daily.
The way we actually determine whether a borrower is actually ahead or behind is compare the actual loan balance with the theorical amortised loan balance. The amortised loan balance reflects a “perfect payment history”. Normally represented by a perfect curve on a loan chart.
To check for arrears – all we need to is check the daily balance of the actual loan balance against the amortised loan balance, if the actual loan balance is equal to or less than the amortised loan balance then they are ok, if it is greater (ie they owe more than then what they should) then they are in arrears. And arrears is simply the difference between the two loans, inversely, equity is also a measure of the difference (just when they are less than the amortised loan).
Now, having said all that, interest only loans can be a bit more of a problem, depending on how money is collected.
Interest Only Loans:
The basis of interest only loans is that the borrower need only pay interest and not the loan balance.
Based on a perfect payment history, there are no problems, however, issues arise if the borrower pays late or more.
If we recap of how interest is calculated, most loans state interest is, “calculated daily, compounded monthly” (based on the daily loan balance)…
So what happens when the borrower is late with their payment? – in reality the loan balance increases. Remember daily loan balance = end of day balance + interest – payment. What should have happened is the interest charge should have been cancelled out by the payment, but because there was no payment, the interest is ADDED to the loan balance, increasing the EOD (end of day) balance.
Now if the borrower makes their payment tommorrow, then the EOD Balance from the day before will be slightly larger, therefore the daily balance will be slightly larger for every day that month, and so forth.
This means the “actual” balance will now always be greater than the “amortised” balance, so even if the borrower makes every other payment on time, they will always now be in arrears (more than like by a few cents). This will trigger arrears and default letters.
So what happens now? Well lets assume the borrower was a day late and gets an arrears notice for 1c, so to cover themselves they pay $1 extra.
Now the loan is ahead by 99c, this means that interest will be slightly less than the amortised loan, so every payment after that will now in fact decrease the loan balance because, daily balance = EOD balance + interest – payment, because the payment is now always larger than the interest charge (because the interest is being calculated on an every reducing principal amount) the borrower is in fact now in a principal and interest loan.
So what is the solution? For banks and other entities that have deposit accounts, they just say that payment (whatever amount) will be deducted automatically for the interest calculated. So there is no reason for the borrower to make a fixed payment.
The other great thing about this system, is that “interest calculated daily, compounded monthly” will vary from month to month, since we can have 28-31 day months.
For small lenders, in most cases they rely of a deposit system of fixed amounts, whether it is by EzyDebit, or such.
The issues with fixed payments is that interest isn’t really being calculated daily and compounded monthly. What happens here is that interest is calculated annually and divided by 12, 26, 52. And as a result cannot accurately compensated for early or late payments, since the amount is fixed. This can potentially disadvange the borrower because they do not get the benefit of extra payments, and the lender, because they cannot charge interest on arrears when they occur.
Also it cannot factor the differences in the days of the month.
And finally, is becomes difficult to determine payout figures. Since fixed payments are based on annual calculations, it is harder to factor a daily loan balance for a payout figuire requested at anytime other than the end of the month.
These are the issues, we have to factor in, in order to create an interest only system.
Actually, to create an interest only system that mirrors the banks is easy, we just remove the principal calculation from the amortised balance, however to create a system that can be used effectively by home-based leaders without access to flexible debiting systems has posed a bit more of a challenge.
So thats the issue in a nutshell. I would like to hear from people currently doing interest only loans. And I would like to know;
– how interest is being calculated
– how payments are being made
– how arrears and extra payments are being managedIf you do not wish to post here, please feel free to email me at [email protected]
Regards
Michael GruberSorry just got a Q on IO Loans…
Isnt the reason why the banks are restrictive with what they do becuase the buy money in a different way to lend to IO opposed to P+I?
So if I became a lender and I offered an IO loan I know the client will only pay interest which means all I need to do is purchase the principle wholesale at a lower rate for the first term. At the end of the first term my client can make a lump sum payment which means the next term I also purchase less money.
I cannot see how you can add more flexibility to IOs? Or have I missed the point???
I guess IO is part of risk management on the loan you cannot reduce P…
Based on this if you offer IO, you dont want extra payments made until end of the term as you are stuck with the purchased money anyway…
Arrears I have seen managed as $$ in arrears charged at Interest Rate + Penalty Rate (2-4%) and accounted as a separate transaction. Incoming payments always pay down arrears first.
Mat
(Im not a lender!!!)Hi,
Isnt the reason why the banks are restrictive with what they do becuase the buy money in a different way to lend to IO opposed to P+I?True, however this topic is to investigate how vendor financiers manage interest only loans. In nearly all cases their funds are either wrapped around an existing loan, or created as a second mortgage to sell deposit finance. In either case the restrictions are different than the banks, and in this topic, do not factor in how they are managed (in terms of collection of payments and handling of arrears).
So if I became a lender and I offered an IO loan I know the client will only pay interest which means all I need to do is purchase the principle wholesale at a lower rate for the first term. At the end of the first term my client can make a lump sum payment which means the next term I also purchase less money.See my comments below about variable and fixed interest loans. Your statement appears to describe fixed interest only loans, however my concern is about managing variable interest only loans.
I cannot see how you can add more flexibility to IOs? Or have I missed the point???There are a number of issues regarding flexibility, such as;
– extra payments – reducing of principal
– arrears – increase of principal
– penalties – possible increase of principal
– changes in interest rates (during the term of the loan – ie variable interest)I guess IO is part of risk management on the loan you cannot reduce P…It is my view that as long as all the variables are managed, in terms of properly managing the loan in compliance with the law, then that risk is covered, my main concern is ensuring that the likes of the Department of Fair Trading cannot indicate that the lender is not disadvantaging the borrower in anyway. See more about this below…
Based on this if you offer IO, you dont want extra payments made until end of the term as you are stuck with the purchased money anyway…Arrears I have seen managed as $$ in arrears charged at Interest Rate + Penalty Rate (2-4%) and accounted as a separate transaction. Incoming payments always pay down arrears first.
However extra payments is not the only thing that can alter the principal, it is common practice for extra charges to be applied to the loan balance. If a borrower misses an interest-only loan payment, then they interest, which should have been paid in full is normally applied to the loan balance, which would mean the principal is now larger, which means higher interest charges for every day that balance is larger, which means a larger interest only payment the next month. And if your payments are fixed (ie using EzyDebit, etc) then the borrower with be in arrears next month, etc, etc
On a side note, here’s some more thoughts…
What needs to be defined here is that there is at least 2 types of interest only loans, variable and fixed.
Variable interest only loans are easy to implement, just calculate the interest on the daily balance and compound monthly. Then charge the borrower whatever the interest amount is.
Very easy to calculate, harder to collect. The reason is the borrower never knows in advance what the interest charge will be. Which is why banks have it easy, they just take the necessary funds out of a linked deposit account.
Whereas fixed interest loans, are easier to run via a debit system like EzyDebit or payments via the borrowers’ employers paymaster.
These type of loans usuallly specify a period where the interest rate will be fixed. Ie 1year fixed interest. During that time, the payments are fixed also (loan balance multiplied by annual % divided by number of payments).
The downside for the borrower with these is that they are unable to make extra payments.
If extra payments were to be allowed, then they would be treated almost like a new loan with a new balance – and with some lenders they ensure that extra payments are made in specified lump sums ($1000, $5000, etc). Again, each lump sum payment would mean the balance and new payments are recalculated. And fees may be applied (to cover the cost of recalculating).
With fixed interest only loans, arrears would be handled like the offset account system, the arrears would sit in a separate system with interest compounding. However with such a system, where interest could be calculated to the cent on a daily basis, it would be too easy for the borrower to overpay (to over estimate the outstanding arrears) and as a result trigger a extra payment penalty. For if they were $95.73 in arrears and they paid $100 to “just fix things up”, how does the lender manage the extra $4.27?
How would you accomodate this $4.27 overcharge? Would you credit them and reduce the loan a $120,000 IO loan balance to $119,995.73 and then recalculate the monthly repayments to $999.96 ?
Or credit their savings account with the $4.27, and absorb the $7 (or more) direct debit charge as a cost, or charge the borrower the $7 direct debit fee, take it out of the $4.27 surplus, and end up with a $2.73 debit which ends up being an arrears of $2.73, which then triggers an arrears notice – and the subsequent arrears notice fee…and so on.
It can get quite silly, I admit, but when your dealing the transfer of small amounts. Sometimes the cost of transfer is larger than the amount being transferred itself.
So why bother transferring at all? Because you want to ensure that the Department of Fair Trading always see that you are always managing the funds correctly, and that means you only keep what you are owed, and any benefit to the borrower is maintained, and this means that if they paid just 1c extra, that 1c is helping to reduce their loan balance.
So how does everyone manage their interest only loans? fixed or variable? Do you charge penalties for over payments, or do accept them at all, what about arrears?
Regards
MichaelI use your product for P+I but have to use the excel sheet for IO and Honeymoon rates.
I would like to see these options in your product.
Dave Siacci
Hi,
In regards to the IO loans you manage, what does your contract say in terms of how the following is determined;
– interest is calculated
– arrears are calculated
– extra payments are calculatedThese questions also apply to the honeymoon rates.
I would like to develop these features, however I first need to understand the user’s requirements. As I mentioned in the original post at the beginning of the thread. It is very feasible to develop a straight variable IO loan system. Although it may not be practical because payments would vary from month to month.
Do you use fixed or variable IO loans?
Michael
I’m very interested to learn more about this stuff….thanks for the very informative posts guys
You must be logged in to reply to this topic. If you don't have an account, you can register here.
