When a consumer loan is prepaid by cash or a refinancing of the debt, there arises the question of whether there are any “prepaid” finance charge or other fees that are due to be refunded to the debtor. More often than not, there are.

That component of Finance Charge that is interest may be partially refundable depending upon whether the stated interest is earned on a simple interest basis (also known as actuarial or daily accruing basis) or on a precomputed basis. If earned daily, then there is no prepaid interest due to be refunded. However, if the interest is precomputed for the entire term of the loan at the outset, then since the entire term has not occurred, there is unearned interest that is due to be refunded in the event of prepayment. The methodology for refunding precomputed interest is known as the Rule of 78’s.

There are other forms of Finance Charge than interest. For example, state law may allow an account handling fee, an acquisition fee, a closing fee, an origination charge, or an interest surcharge. Depending upon what the law provides, these fees may be fully earned and non-refundable from the outset of the loan; or, they may be refundable on a pro rata basis, or refundable on a precomputed basis, or some combination of these methodologies.

Also, the rules respecting refund are often term sensitive. For example, interest may be refundable on a precomputed basis if the loan term is less than a certain number of months; but, if longer, then interest must be earned on an actuarial or simple interest basis. Yes, it’s complicated. One must understand the law or regulation that authorizes the fee that is a Finance Charge in order to understand the refund requirements for the fee in the event of prepayment.

Now, these clear examples of Finance Charge are not the end of the story. There are a variety of fees permitted to be charged to debtors that are in the nature of a “cost of credit” but are excluded by law from being considered Finance Charge; thus, they are not refundable under either of the two methods in the event of prepayment. Title, credit insurance and recording fees fall under this category. 

Understanding how a loan can be structured is a little bit like playing Wordle—The New York Times five letter word game in which you are given six tries to solve the 5-letter word puzzle. Figuring out five letter word choices is just part of the challenge. Knowing where the five letters must fit to make the correct word is how the game is ultimately won.

Selecting the type of charges to utilize in one’s loan model is an important first step. Understanding what happens to those charges in the event of prepayment, is pretty darn important, too.

Please Note: This is the two hundred-fifty-first blog in a series of Back to Basics blogs, in which relevant and resourceful information can be easily accessed by clicking Dentons - Consumer Finance Report. To receive weekly insights to your email from the Consumer Finance Report blog, subscribe here.