EARLY SETTLEMENT UNDER THE CONSUMER CREDIT ACT 1974

SPECIAL NOTES

The new rules apply to all agreements

From February 2011, agreements covered by the Consumer Credit Directive will be allowed to use any reasonable form of settlement calculation, and the actuarial calculation must be regarded as the benchmark for what is reasonable..

The new rules:

The new scheme uses an actuarial rule for costing the value of the loan against the values of the payments at the time of settlement. The formula is:

Which works out the rebated amount to settle the loan, as described on the attached Excel spreadsheet but please note that this is work in progress (occasioned by so many colleagues asking me to provide an alternative to the Dualcalc program which the Office of Fair Trading made available.

Download Dualcalc here. I make it available since the OFT has stopped supporting it, following the death of its programmer, Brian Stewart, but can offer no guarantee as to its usefulness.

The old rules:

Firstly, we need to distinguish between the two main types of interest calculation in common use within the credit industry :

• PRE-COMPUTED INTEREST - where the total amount of interest is known at outset, and is declared on the agreement, the APR being fixed; hire-purchase and traditional loan agreements are of this form and are known as fixed sum credit agreements
• PERIOD RATE INTEREST - interest is calculated on the balance outstanding at the end of each period; the APR being variable. The commonest period rate agreements are for credit cards, store cards and budget accounts (known as running-account credit agreements ), but you should also be aware that some fixed sum credit agreements also charge interest on a period rate basis.

EARLY SETTLEMENT

A debtor under a regulated consumer credit agreement, i.e.. for an amount up to £25,000, is entitled to discharge his or her indebtedness at any time (s.94). The debtor may also demand, from the creditor, a statement of his or her liability (s.97).

A settlement rebate is available (s.97) only where the credit is a fixed sum agreement, i.e.. where a single advance of credit was made at the start of the agreement, not where it is running-account credit.

Rebates are given assuming a delay or 'penalty' of

• 2 months (if the agreement is not more than 5 years long) or
• 1 month (if the agreement is more than 5 years long).

The penalty is designed to compensate creditors for the initial costs of setting up and administering the agreement.

It is not compulsory for a creditor to charge the penalty - the Act merely lays down a maximum level. Settlement will normally take place on the next available repayment date.

CALCULATING THE REBATE

The calculation is not all that easy to explain. Bear in mind that, in any fixed-sum agreement, the proportion of interest used up in the early months is very much greater than in the later months. (If you have experienced an annual repayment mortgage statement from a building society, you will already understand this!)

For many years lenders have used a system called "Rule of 78" to work out rebates. There follows a short explanation of Rule of 78, but please do not worry if you do not understand it. It is enough to recognise that it exists, and to be able to apply its results.

The Rule of 78 is so called because

Its usefulness is demonstrated in the following example, where we use an agreement in which a loan of £100 is repaid by 12 monthly instalments of £10.
We can represent this agreement on a diagram where we show how the total balance outstanding reduces in monthly steps over the full length of the agreement.
Thus, the debtor owes £120 during the first month, then repays £10 and so owes £110 during the second month, and so on.

Balance (£)

If you count the number of small squares in the above diagram, you will find that there are 78. In fact, you are just counting 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 + 12, these being the number of squares in each column, starting from the right hand end of the diagram.

All "Rule of 78" does is to divide the total interest charge under the agreement up equally between the small squares. Thus there will be 12/78ths of the interest used up in the first month, 11/78ths in the second, and so on... down to 1/78th in the final month.
Now, of course we can only use 78ths when we have an agreement with 12 payments. To calculate the total number of squares (S) when we have n repayments, we use a formula:

GENERAL REBATE FORMULA

The general formula for a rebate (R) is then:

where n is the total number of instalments, m is the number of remaining instalments to be paid, and K is the total charge for credit.

This formula can be simplified to

A SIMPLE EXAMPLE OF THE EARLY SETTLEMENT CALCULATION

Fred Smith buys a car on hire purchase. The cash price is £4000, and he pays £1000 deposit. The credit terms are that he pays 36 monthly instalments of £120, at an APR of 28.6%. Fred makes 14 payments on time, and then decides to pay it off. What will he have to pay?

The calculation is in four parts:

(1) - Working out the total charge for credit:

(2) - Working out the settlement date:

The relevant rule here is "Rule of 78 + 2", because settlement can be delayed by two months, i.e.. settlement is to take place at the date of the 15th instalment, but it is to be calculated as at the date of the 17th instalment.

At this point, there will be the 18th, 19th, ...... 35th, 36th instalments remaining, i.e.. m = 19.

(3) - Applying the rebate formula:

Here m = 19, n = 36, K = 1320.

i.e. - Rebate R = 19 x 20 x 1320 = 380 x 1320 = £376.58
                         36 x 37                   1332

(4) - Calculating the final liability:

The results obtained so far are not the final answer, because we want to know Fred's final payment. Fred has to pay a total of

REBATES ON VARIABLE-RATE AGREEMENTS

Certain fixed sum credit agreements have variable APRs, such as those offered by First National Bank and Lloyds Bowmaker. These agreements have no fixed lengths nor a known total interest charge because both will depend on future payments and interest rates (although the agreement itself may state estimates of the length and total amount payable).

In order to use Rule of 78, we have to project the agreement forward from the point of settlement until completion, assuming that the interest rate and payment rate remain as at the present date. The remaining length and total charge of the agreement are then determined, and the rebate calculation carried out using the same procedure as if the agreement had pre-computed interest, as explained above.

If you want to settle such an agreement, beware of the following accident of the mathematical formula behind Rule of 78.

The following two graphs show the same loan £5000, repaid at the same APR cost, but the first over a 3 year period, the second one over a 20 year period. The lower line in each graph shows the mathematical settlement line, produced on an accountancy calculation basis, the top line the cost of settlement using Rule of 78. The top graph assumes a two month penalty, the loan being for a period less than 5 years; the bottom graph a one month penalty, being for a longer period.

While the first graph shows a good match between the Rule of 78 line and the reducing balance line. However, the second graph shows that the balance increases over the first third of the agreement, and only gets back to the amount borrowed by about the second third.

It follows that where you have a long term loan, the settlement figure may be significantly higher than the current balance.

If the agreement allows you to make lump sum payments to reduce the capital outstanding, you are advised to pay off almost all the current balance. Then request a second settlement figure. Because the balance will be so small, the effect of the second graph is removed, and the extra amount due on settlement will be minimal.