We often think of prepayment in terms of the voluntary decision of the consumer to pay-off his or her indebtedness in full before the final scheduled due date. But, prepayment of the debt can take several forms.
In addition to the voluntary prepayment of the entire debt, prepayment may be less than the entire amount of the debt—it may be partial. Prepayment may also occur in connection with the renewal or refinance of a debt.
Partial prepayments certainly will reduce the amount of finance charge ultimately paid by the consumer on the debt. However, the contract usually provides that partial prepayments are applied in inverse or reverse order. This just means that the next payment due date does not change as a result of the partial prepayment.
So, in any of these prepayment scenarios just how is the unearned finance charge and any insurance premium refund determined? The answer should be found in the language of the contract.
If a contract (whether a note or an installment sales contract) calls for the computation of interest on a simple interest basis, then at the time of prepayment unearned finance charge should be determined on an actuarial basis. If a contract computes interest on an add-on or precomputed basis, then unearned finance charge should be determined by the Rule of 78s. Click here for an explanation of the difference between simple and pre-computed interest.
Which brings me to a discussion of determining the unearned finance charge at a point of involuntary pay-off. That is, at the time that a customer files bankruptcy or a finance company accelerates the debt and files a collection law suit, what is the unpaid balance? Depending upon the method that the contract calls for in computing finance charge, the unpaid balance—the gross balance less the unearned finance charge—will differ.
If finance charge is earned on a simple interest basis, then an actuarial refund will result in a collection complaint or a bankruptcy claim of a smaller unpaid balance. If the finance charge is earned on a precomputed basis, the unpaid balance will invariably be higher, and the claim will be for a larger amount.
Too often there is misunderstanding by lawyers, trustees and judges as to the proper method to determine the unpaid principal balance of the contract giving rise to the claim. It is incumbent on creditors to understand the finance charge terms of their contracts and be prepared to step their collection lawyers through the methodology of determining the unpaid balance due at time of suit or claim.
Please note:This is the fifty-eighth blog in a series of Back to Basics blogs, in which relevant and resourceful information can be easily accessed by clicking here.