Discussion Paper Summary

April 2000

Consumer Credit Law Review, Part 3: Transparency in Consumer Credit: Interest, Fees and Disclosure

Provision of information to consumers
Disclosure of the cost of credit in New Zealand's consumer credit law
Problems with the finance rate
Transparency issues with the early repayment of loans
Options for reform

This is the third public consultation document to be released by the Ministry of Consumer Affairs as part of the Consumer Credit Law Review. It discusses the issue of the transparency in consumer credit law, or what information is given to a consumer, how, when and in what form. The timing, content, format, and presentation of information all influence how useful that information will be to consumers. The paper discusses:

• what information should be disclosed by lenders under a credit contract (including hire purchase and other related contracts) and how it should be presented?
• problems with finance rates
• what method of calculating interest charges is fairest for consumers?
• what right should borrowers and lenders have when the borrower seeks to repay a credit contract before its term has expired?

Transparency will not eliminate all the difficulties faced by consumers in credit deals, but it will help make them better informed and more confident in their dealings. Lenders, in turn, will also benefit through a more efficient market.

Provision of information to consumers

To ensure that consumers are well-informed, information provided to them should be:

• accurate: the information provided should allow consumers to draw clear conclusions about the cost of credit : the information provided should allow consumers to draw clear conclusions about the cost of credit
• comparable: information provided by different lenders should be comparable so that consumers can make meaningful choices between competing offers: information provided by different lenders should be comparable so that consumers can make meaningful choices between competing offers
• clear: as far as possible, information should be presented clearly and in a consumer-friendly way : as far as possible, information should be presented clearly and in a consumer-friendly way
• concise: concise documents are more likely to be read and understood – and help keep search costs down for consumers
• timely: consumers should receive all the essential information they need before becoming irreversibly committed to a credit deal: consumers should receive all the essential information they need before becoming irreversibly committed to a credit deal

Many of these principles are difficult to achieve through legislation. The discussion paper looks at how the principles could be achieved, and any barriers that currently exist which prevent them from being achieved. Two problems identified include:

1. The price and terms of modern credit products are typically very complex. This provides a challenge for disclosing meaningful information. Twenty years ago a standard loan was for a fixed amount with a fixed interest rate. Today, there are "revolving" credit products with many variations, including "fleximortgages" and different types of credit card, and these are becoming more popular than the traditional "instalment loan".
2. The poor literacy and numeracy of a significant number of people. Many New Zealanders cannot read and understand even a relatively simple financial document, let alone a complex credit contract.

Disclosure of the cost of credit in New Zealand’s consumer credit law

The key statute requiring information disclosure by lenders to borrowers or prospective borrowers is the Credit Contracts Act 1981. The most important disclosures for fixed credit products are the:

1. total cost of credit – all interest and (most) other charges must be disclosed as one figure
2. annual finance rate – this expresses the total cost of credit as an annual percentage rate of the amount of credit outstanding on the loan.

However, these items are not required to be disclosed for revolving credit products.

The annual finance rate provides a standardised measure of the cost of credit that includes interest and other charges. It accounts for the timing and amount of all advances and repayments. Before annual finance rate disclosure was required, lenders used a variety of methods to disclose interest charges.

Problems with the finance rate

There are problems with the finance rate which relate to the principles of accuracy, comparability, clarity and timeliness. The problems are:

• it does not include all relevant charges paid by the consumer, which reduces its effectiveness as a tool to rank the cost of different credit arrangements
• finance rates cannot be used by consumers without further interpretation; this interpretation can be complex – probably too complex for most consumers
• disclosure of the finance rate, and the cost of credit generally, is usually made too late to be used by consumers in a "comparison shopping" process
• it is difficult to calculate an accurate finance rate for revolving credit products
• finance rate calculations are complex and legislation is further complicated if it has to tell lenders how to calculate a finance rate.

Another issue is the complexity and less-than-helpful formatting and presentation of many credit contracts.

Transparency issues with the early repayment of loans

Borrowers in New Zealand do not have a general right to repay a loan early, except for hire purchase contracts. Mortgage contracts also give borrowers a right to repay early, but the borrower may be charged the interest on the full term of the loan. In most cases, borrowers may only repay a loan early if this right is stated in the contract.

If the borrower does choose to repay a loan early, he or she may face the following charges:

• an administrative charge for the cost of processing the early repayment
• a proportion of the interest that would be payable if the loan was to run its full course – this is most relevant to hire purchase contracts, whereby lenders may retain ten per cent of the interest calculated over the entire loan
• an "early repayment adjustment" – if a borrower makes early repayment of a loan with a fixed interest rate, the lender may seek to recover its loss if interest rates have dropped at the time of early repayment
• a hidden charge resulting from the method used by the lender to calculate the rebate of interest. This is especially the case when the lender uses the so-called "Rule of 78" to calculate the amount the borrower must pay to end the loan. The Rule is widely recognised to be inequitable, as the borrower effectively pays an additional amount to the lender.

Options for reform

The Ministry believes that consumer credit law can be reformed to better achieve transparency. There are two alternative approaches.

1. Reform the finance rate in the Credit Contracts Act

Key reforms that would make the finance rate work better would involve:

• clarifying the charges to be included in the finance rate calculation ensuring that all relevant fees are included
• Using a more accurate method of calculation for the finance rate.

2. A synthesised approach

This approach would no longer require lenders to calculate and disclose the finance rate. Rather, it would:

• regulate interest calculations – by specifying that the interest cannot be more than what would be calculated by applying a daily interest rate to the daily balance
• regulate fees – this could be done in several ways, such as limiting the fees that lenders can charge, or giving the power to Courts to review fees against certain criteria
• simplify the disclosure requirements – there are two options i) legislation could prescribe the information that must be disclosed by all lenders; ii) legislation could set a broad standard for the disclosure of information while leaving the exact detail up to lenders. Either way, the purpose is to bring the key terms of the contract to the attention of the borrower.

Cooling-off period

The Ministry believes that legislation should continue to provide a "cooling-off" period, giving the borrower three days to cancel the loan after signing up for it.

Timing of information disclosure

One of the most difficult problems with consumer credit is how to make lenders present information to consumers before the consumer becomes psychologically committed to a particular deal. One means of achieving this would be through a "centralised" third party disclosure regime. This would involve an agency collecting cost of credit information from lenders and publishing it centrally, so that consumers could compare prices. However, it is an untested model, and would have to be established, administered, marketed and funded.

Early repayment

Lastly, some options are put forward to help make it clear what the rights of the consumer are when they seek to repay a loan early. The Ministry proposes that consumers should have the right to repay any loan early. However, the lender should also be able to recover a reasonable amount for any loss resulting from the early repayment. More equitable and transparent methods for calculating early repayment rebates than the Rule of 78, such as the "actuarial rule", are also discussed.

Discussion Paper - full text

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