There is only one disclosure in the entire Federal Box of the Truth-In-Lending Act disclosure statement that differs depending upon the manner in which the Finance Charge is computed. That is the disclosure that addresses what happens upon prepayment.
Finance charge is generally computed on one of two bases: either on a simple interest basis (commonly known as interest-bearing) or on a precomputed interest basis (commonly referred to as add-on interest). Recall that I addressed the differences in the manner that finance charge is computed in our August 29, 2018 blog:
So, the methodology for computing unearned finance charge in the event of prepayment differs accordingly. If finance charge is computed on an interest-bearing basis, the unpaid balance due to be refunded in the event of prepayment in full is the unpaid principal plus accrued and unpaid interest. There is no unearned finance charge to be refunded.
On the other hand, if the finance charge is computed on an add-on basis, then the unpaid balance includes precomputed interest that is due to be refunded to the customer. Most states allow such precomputed interest to be refunded by the Rule of 78's. *
If the finance charge is computed on an interest-bearing basis, then Regulation Z of Truth-in-Lending mandates that the prepayment disclosure tell the customer whether or not the customer must pay a penalty in connection with the prepayment.** This is known as the (k)(1) disclosure. If the finance charge is computed on a precomputed interest basis, then Regulation Z mandates that the prepayment disclosure tell the customer whether or not the customer will be entitled to a refund of any finance charge upon such event. This is known as the (k)(2) disclosure.
The fact is that these two disclosures are sometimes mixed up. That is, the (k)(1) disclosure may be inadvertently given in a precomputed loan transaction; and, vice versa. This is an unfortunate occurrence that can lead to damages for a violation of the Truth-in-Lending Act.
One more interesting tidbit: In some loan transactions, there are both kinds of finance charge assessed. That is, one component of finance charge may be assessed on a precomputed basis, while another component is assessed on an interest-bearing basis. In such circumstance, both the (k)(1) disclosure and the (k)(2) disclosure should be given.
Practice Pointer: Take a look at your prepayment disclosure and understanding how finance charge is computed, make certain that you are giving the correct disclosure.