Credit Contracts and Consumer Finance Act 2003: Proposed Regulations

November 2003

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1. Safe Harbour Formula for Calculating a Creditor's Loss Resulting from a Full Prepayment

• Introduction
• The Act's Rules Relating to Full Prepayment
• The Formula in Detail
• Example
• Limitation of the Formula
• Formula Is Voluntary

Introduction

The CCCF Act introduces new rules for the early repayment of a credit contract by debtors. It also introduces new terminology:

• "full prepayment" refers to payment of the entire unpaid balance before it becomes payable;
• "part prepayment" refers to payment of an amount less than the unpaid balance before it is payable.

The concepts of prepayment are applicable to instalment credit contracts, i.e. credit contracts where the amount to be advanced and the amount and timing of payments under the contract is known at the outset.

The term "prepayment" is not applicable to revolving credit contracts, which are credit contracts that anticipate multiple advances with the amount and timing of advances and payments not being known.

The Act's Rules Relating to Full Prepayment

The rules relating to prepayment in the Act are:

1. Debtors have the right to full prepayment under a contract at any time (s 50(1)).
2. The amount that a creditor may require a debtor to pay for full prepayment must not exceed the sum of the following:
   • The unpaid balance (being the amount outstanding of preceding advances, and fees or interest charges debited to the balance, less payments made by the debtor).
   • Interest charges and fees that have accrued up to the date of the repayment.
   • Fees to cover the administrative costs relating to the repayment (provided such fees are authorised by the contract).
   • A rebate of any consumer credit insurance product financed under the contract.

   And, importantly for the purposes of this paper:

   • A charge that does not exceed a reasonable estimate of the creditor's loss arising from the prepayment.

The Act does not define "loss" but the Courts are expected to draw an analogy with the doctrine of penalties relating to damages for breach of contract.

Thus, "loss" includes the gains the creditor would have made if the contract had run its course and there had not been full prepayment. Applying contract damages principles, the "loss" is mitigated as follows:

• As a damages award involves early payment of amounts due in the future, the award will be discounted to its present value.
• Secondly, the creditor must mitigate its loss by reinvesting the amount paid on full prepayment. This occurs when the creditor re-lends the money under a subsequent credit contract at its prevailing interest rate. The profit from this second contract is set off against the foregone gain of the first. If the prevailing interest rate is lower than the original rate, the creditor would have suffered a loss.

Section 54(1) provides that the loss is to be calculated according to an appropriate procedure specified in the credit contract. ("Appropriate" means effective at providing a reasonable estimate of the creditor's loss, as required by s 54(2)). Alternatively, the creditor may use the procedure provided in regulations made under the Act.

Use of the procedure in regulations provides a safe harbour for the creditor. Provided the creditor has applied the formula correctly, the creditor is assured that the charge does not exceed a reasonable estimate of its loss and is free from any challenge.

The Ministry of Consumer Affairs recommends the formula laid out on the following pages. The formula is based on the positive difference between the present value of the remaining payments due on the loan and the present value of the payments that would be received if the amount paid early is re-lent for the remaining term at the creditor's prevailing interest rate.

The interest rate to be used for determining the present values is the rate at which the creditor would make an advance for the outstanding amount to a customer of the same risk for a period equal to the remaining term of the original contract. This is to be based on the creditor's prevailing rates.

Where the exact remaining term is not offered for new lending, the lender may use the interest rate for the closest available term (either shorter or longer).

The second present value above, that of the re-lent payments, is equal to the unpaid balance of the loan.

The Formula in Detail

The value of the loss can be calculated exactly using the actuarial formula given below.

where

VFP	=	Value of forgone payments, i.e.:
f	=	the payment frequency of the terminating contract
v	=
i	=	the annual interest rate currently offered on a credit contract of the same type and risk as the original contract, but with a term equal to the remaining term of the original contract.
n	=	the number of payments remaining on the original contract
d	=	the number of full days since the last payment due date [1]
P	=	the payment per period for the discontinuing contract

Example

The effect of the formula can be seen in the following example.

Creditor makes an advance to Debtor with the following relevant terms:

Six months into the term, Debtor seeks to prepay the loan in full. The unpaid balance is $3859.62.

The number of days since the last payment is 5.

The annual interest rate for an equivalent loan of 18 months duration is 10%.

The lenders loss can be calculated thus:

The loss to the creditor is $3,924.23 (VFP) - $3,859.62 (unpaid balance) = $64.61.

Although the formula may appear complex when laid out as an actuarial equation, it is quite straightforward and can be easily programmed into a spreadsheet. An example can be found in the following spreadsheet:
→ Credit Contracts and Consumer Finance Act 2003: Calculation of Loss to Lender as a Result of Full Prepayment: s 51(1)(c) [26 KB Excel 97 File]

Limitation of the Formula

The use of the formula applies to loans that have the features given in the examples above, i.e. equal-sized payments and payment periods. The formula may be difficult to apply to loans with complex or unusual features. In such cases, the creditor will have to work out an appropriate formula.

Formula Is Voluntary

Remember that the use of the formula is optional. This means that creditors may frame the full prepayment charge differently from the way it is provided in the formula. The charge will be valid, so long as it can be shown not to exceed a reasonable estimate of the creditor's loss.

[1] Under the Act, interest is only payable at following the end of a full day (s x).

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