Tim Madden is an economist with expertise on credit and banking. Tim and I are colleagues in lobbying government for public banking, with concentration in the US for state-owned banks (and here). The structural solutions to our economic controlled demolition are obvious and simple; and explained beautifully by many of America’s brightest historical minds.

Tim’s following article is brilliant. He can be reached at: timothypmadden@gmail.com

This is part 2 of 3. Part 1 is here, part 3 tomorrow.

How can something as manifestly important as a certain way that financial institutions calculate the amount of interest due from borrowers be recognized and prohibited as criminal fraud in the U.K., while concurrently being required by law in the U.S. under consumer protection legislation?

How can 24% per annum be “equal to” 0.058952% per day on a U.K. credit card, but 0.065753% per day in the U.S. and Canada? The difference since 1974 when the U.S./Canadian method was criminalized in the U.K. now accounts for an amount greater than all outstanding consumer debt in the U.S. and Canada.

Calculated to deceive

The U.S. (and Canadian) nominal method is criminal in the U.K. for very good reasons.

The following comparison has been designed so as to demonstrate the cost of the nominal method in terms of dollars out of a borrower’s pocket instead of just rate differences. Because most consumer interest payments are made monthly we will deal with the application of the nominal method to monthly interest charges or “calculating monthly” as it is sometimes called in the finance business.
The nominal method is also referred to as the “straight division” method because the lender takes the stated annual rate and then divides both components of the rate by the number of payment periods in a year. For example, if a borrower agrees to pay interest at 12% per annum by monthly payments, then the lender will go into her account and assess 1% each month.

Most American (and Canadian) consumers think this procedure is correct. Financial institutions are in the business of knowing that it is not. It would not be such a problem if the error were consistent, but, again, the nominal method error increases exponentially in favor of the lender as the stated annual rate is increased. At the higher levels associated with credit card rates the error is positively obscene.

The first step is to be certain to compare like things, and to use a long enough period so as to clearly demonstrate the significance of the thing being measured. A 30 year period is used here because it is the standard amortization period on a residential mortgage in the U.S.

Using \$100,000 as a comparison loan amount, over 30 years at 6% per annum using the nominal method, the required monthly payment will be \$599.55. If the interest charges were determined at a real 6% per annum, then the monthly payment would be only \$589.37. Comparing two different monthly payment streams, however, using two different calculation methodologies, would confound the results. To determine the extra cost of the nominal method, and only the nominal method, it is necessary to compare identical payment streams applied against identical loans where the one and only difference (single variable) is the calculation method. Given a fixed loan amount (\$100,000) and a fixed monthly payment amount (\$599.55) the only way to measure the extra cost in dollars is by the time (and total payments) required to pay off the debt/contract (the amortization period).

At a real 6% per annum a \$100,000 loan requires 28.67 years to pay off with monthly payments of \$599.55. If the lender uses the nominal method, then the same loan takes exactly 30 years to pay off based on the same monthly payment. The cost of the nominal method is slightly less than 16 extra payments of \$599.55 for a total of \$9,564 per \$100,000 borrowed. The total interest cost is the total payments (360 months x \$599.55 = \$215,838) minus the principal sum loaned (\$100,000) with the result being \$115,838. The \$9,564 difference (the Bankers’ Bonus) from the use of the nominal method therefore represents a 9% increase in the total dollar cost of borrowing, or about 8.25% of the total interest money paid/collected over the 30 year period.

What then happens to the extra cost when the same technically incorrect nominal technique is applied at 15% per annum? That is the approximate weighted average stated lending rate over the 30 year period 1974 to 2004 (about equal to prime plus 3%). Does the error stay the same at about \$9,500? Does a two and a half times increase in the stated rate from 6% to 15% cause a similar increase in the extra cost from \$9,500 to about \$23,000 for each \$100,000 borrowed? Or is there something more but which bankers never talk about publicly?

Again the example is a \$100,000 loan repaid over 30 years and at a “nominal” 15% per annum the required monthly payment is \$1,264.44. If interest were at a real 15% per annum, then the monthly payments would be about \$75 less at \$1,189.46, but once again we want to isolate the extra cost of the nominal method and so that is the assumed (or control) payment amount. At a real 15% per annum a \$100,000 loan requires 18.68 years to pay off based on monthly payments of \$1,264.44. If the lender uses the nominal method, then it takes exactly 30 years to pay off the same loan with the same monthly payment. Now the cost to the borrower is 135.88 extra payments (11.3 years) of \$1,264.44 per month or \$171,806 per \$100,000 borrowed!

Here again the total interest cost is the total payments to be made (360 x \$1,264.44 = \$455,198) minus the principal sum loaned (\$100,000) with the result being \$355,198. Now the \$171,806 difference represents a 93.68% increase in the total dollar cost of borrowing or 48% of the total interest paid/collected over the 30 year period. The interest cost should be \$183,436 over 18.68 years but at this higher level the error in the nominal method adds 11.32 extra years to create a debt with total interest payments of \$355,198.

What may appear to be a near trivial difference is actually a form of mathematically engineered leverage which increases the total cost of borrowing (cost of the contract) by 93% at a stated interest rate of 15% per annum. A mortgage or any term loan is designed with the monthly payment amount determined so as to be just slightly more than the initial (first month’s) interest cost so that the loan will take 30 years (or whatever desired amortization period) to pay off. By using the nominal method, at any given rate, the creditor gets to both collect larger payment amounts which pay down the loan relatively quickly at the rate stated and collect those larger payments for 30 years anyway.

It is also irrelevant that many lenders no longer make loans for fixed terms of 30 years. The 30 year period is simply a standardized reference period by which to demonstrate the radically different effects of the same math error at different “nominal” interest rates. At 15% per annum, over any given 30 year period, lenders will increase the total amount of interest money exacted from all borrowers by 93% by simply using the nominal method.

Of course the loan agreements don’t actually say “the nominal method”, much less explain what it means. In Canada it is simply the explanation given if and when (rarely in practice) a borrower discovers that their monthly payment does not correspond to the rate of interest stated and declared in the agreement. In the US there is no need for an explanation because the nominal method is required by law. The 6% and 15% per annum examples are highlighted in the table below.

At the nominal 30% annual rate on many department store credit cards the monthly payment needed to retire a \$100,000 debt over 30 years is \$2,500.34. If the calculations are done correctly, then the same debt is retired after 8.21 years based on the same monthly payment. At a stated 30% per annum, a real 8.21 year debt costing \$146,000 in interest is leveraged by the nominal method into a 30 year debt costing \$653,000 in interest!

(tables to show the data are provided by Tim, but the data exceeds Examiner.com’s capacity. Please contact Tim at the above e-mail to receive the tables.)

The second column from the right in the table gives the relative increase in the cost of borrowing. Lenders may claim that money is inherently less valuable in a world with 15% interest rates than in one with 6% interest rates and that it is therefore not fair to simply compare the extra money cost of the nominal method. The \$171,800 extra cost at 15%, however, is almost 18 times greater than the \$9,564 increase at 6%, representing an absolute increase of 1,800% in terms of extra dollars out of the borrower’s pocket from the math error, per se. What the second column from the right shows is that regardless of the relative value of money, the nominal method will cost the borrower 93.68% more of it at a stated 15%, compared to only 9% more money at a stated 6%. The nominal method presents a new and substantially greater real error with every marginal increase in the stated annual rate.

Part 3 tomorrow: Problem much greater still