Truth in Lending Bill, Hearings Before a Subcommittee of ..., 87-1 on S.1740 ..., July 17 ... 27, 1961

Apparently installment credit has interfered very little with thrift in one form or another. Even if it had interfered to some extent, it might still have been justified, for there can be just as much wasteful saving as there can be wasteful spending. It is possible to save too much, just as it is possible to spend too much. What is needed is wise and intelligent saving, just as we need wise and intelligent spending.

Installment credit is costly

Probably one of the most serious objections to installment credit is its costliness. In addition to interest on outstandings, and losses from bad debts, high costs of collecting accounts are generally incurred, except in the case of the more reputable stores. Because of the chance of repeated default in payment, elaborate means must be provided for enforcing payment while at the same time keeping the customer satisfied with his purchase. The repeated handling of collections alone involves an appreciable cost in this type of credit. For these and other reasons, payroll cost is the largest or second largest item of expense in installment credit operations.

Exorbitant charges and misrepresentation

Critics of installment credit give the impression that, because administrative costs of this type of credit are necessarily high, charges for it are exorbitant. It is true that both costs and charges are high and that some vendors abuse it by making exorbitant charges for the service. It does not generally follow, however, that charges are exorbitant in the sense that they are illegal, unfair, or misleading. Unfortunately, few consumers know, or even care, what installment charges they pay and, therefore, are sometimes surprised to learn how high they are. But consumer education, State provision for maximum sales financing rates and other charges, and Federal Trade Commission policing of advertised rate statements have measurably reduced abuse and deception with respect to charges.

Not only rates charged but other installment sales practices have shared criticism. These include concealment of charges; rebates and bonuses given by finance companies to dealers; extra charges or "packs" added by the dealer to the amounts required by the finance companies; special fees for delinquency, recording of the credit instrument, and refinancing past-due amounts; hasty repossessions and "fixed" auction sales; taking extra security such as wage assignments and endorsements of other parties; overcharging for insurance and failure to place insurance paid for by purchaser, as well as requiring extra coverage; inadequate or no refunds for payment of unpaid balances before they are due; and one-sided legal protection provided for in the sales agreement. Methods of computing true, actual, or effective rates of charge

It is often argued that the best assurance against certain undesirable installment practices is a knowledge of what rates are actually charged on installment transactions, if any such charges are specified separately in dollar amounts. Knowing this, it is alleged, a consumer would be in a position to take or reject an offer, or to find alternative means of financing his purchases, assuming, of course, that such alternative means are available to him.

First, it is important that rates of charge on installment transactions should not be confused with interest rates charged for the mere use of money,' since the part for the total charge for the use of money is much smaller than the remainder of the charge which is made largely for service connected with credit granting, recordingkeeping, and collections. Stated in another way, the cost of money to the installment credit grantor, both explicit and imputed, even in the broad terms explained in footnote 3, is seldom over one-third of his total cost of such an operation.

What is suggested here is that comparison is facilitated by the consumer and others involved when the installment credit charge, interest and service, is expressed not only in amounts but also as a rate per annum under the so-called time-price principle or doctrine. To be of greatest usefulness, such a rate must be determined when the transaction is consummated. To do that may be utterly impossible, extremely difficult, or at best only approximate.

Even what is normally regarded as interest for the mere use of money actually consists of three parts. One is what the economist treats as pure interest in terms of rent paid for the use of capital in which no risk or expense is involved. Another is payment for the risk assumed through possible loss of principal. A third part is in the nature of a reimbursement for management expenses incurred in making and servicing an ordinary loan that is repayable in a lump sum and a net profit on the transaction.

In some types of credit transactions, as in revolving credit where the charge is based on the month-end balance, an actual rate on average outstandings during the month can never be determined either in advance or even after the fact in the absence of prohibitively costly records of daily average outstandings for each such account. In most other instances vendors would not know how to determine an actual rate of finance charge on a per annum basis from the quoted rates, the difference being that the former is based on the amount of debt outstanding at any given time while the latter is based on the original unpaid balance of the principal when the arrangement was effected.

Even among authorities on the subject there are substantial differences of opinion as to proper or best method of converting a so-called nominal rate of charge, such as is often quoted, or the amount of charge in dollars, into a socalled effective or actual rate per annum. Although the traditional amount of time used in financial matters for the computation of rates is the year, there are differences in both opinion and practice as to whether the calendar year of 365 days shall be used or a year of only 360 days in terms of 30-day months. As to which year length is to be used may become crucial in figuring the time elapsed between two dates within a year on large sums of money.

Much more important is the choice of method for converting finance or credit service charges into annual rates. To this end there are several possibilities. Obviously, the actuarial method is by far the most accurate but also the most complicated. Hence, resort must be made to some other method. One in common use is what is known as the constant ratio method, whereby a constant fraction of each payment is allocated to the finance charge and the remainder to the repayment of the principal or unpaid balance. Another is the direct ratio method, based on the month dollars in actual use by the consumer and is often referred to as the "78th's method" or the "sum of the digits method" according to which the finance charge is allocated among the months in direct ratio to the total month-dollars in use by paying twelve seventy-eighths of the finance charge in the first month, eleven seventy-eighths in the second month, etc. Then there are the minimum yield and maximum yield methods depending upon whether the finance charge is deducted from the earliest or the latest payments.

After an appropriate method for making the computation has been chosen, there still remains choice of the procedure or process of actually making the computation. For this purpose a number of varying procedures have been developed including different formulas or other short cuts. As to which is best even for a given method, authorities differ widely. This, in turn, has led to the preparation of charts and “gimmicks” which, in the opinion of some students of the subject, facilitate the task and in the opinion of others are deemed to be absurd, at best only approximate, or not fitting varying conditions and differing credit arrangements.

Because of all these difficulties, it would be too much to expect the average businessman to know how to make the computation and certainly it would be preposterous to expect consumers to know much about it. What is, therefore, intended in the following discussion is to present a method of computation for students of the subject as prospective managers of credit and for those already engaged in that type of management activity in order that they may be more sophisticated about it. Even this is intended to apply mainly to large individual sales of the regular installment type.

For the sake of a logical approach to this problem, as well as in the interest of simplicity, a method for computing the actual rate of charge per annum, no matter how the charge is quoted, is suggested below and the computation is to be made in five simple mathematical steps as indicated:

1. Determine the cost of the credit required. The cost of installment credit is usually expressed or ascertained in one of three ways: as a percentage carrying charge; as a dollar-and-cents carrying charge; or as a differential between credit and cash prices. The first and the third methods are perhaps the most common, although it is not unheard of that the installment charge should be a combination of two of these forms. Consequently, the first thing to determine in figuring the actual rate is the sum of the costs incurred.

Suppose, for example, that merchandise such as a refrigerator, priced at $400 is sold on the installment plan and that a charge of 6 percent is made for the financing service. The charge remains the same although it may be stated that $4 must be paid for investigation, $3.50 for opening the account. $8 for the interest on the outstandings, 50 cents for filing the chattel mortgage, and $8

for other services. On the other hand, the merchandise may have been priced as follows: "Installment price-$424; cash price-$400." Thus the same charge is shown to be expressed in different ways. The charge actually involved, however, is complicated by the combination of these methods of expression and by the fact that the consumer is not adept at figuring the rate when a cash discount is offered from the installment price of the goods. Nevertheless, it is imperative to state in terms of dollars and cents the total cost incurred by reason of the use of installment credit.

2. Determine the amount of credit required.-The amount of credit needed in any transaction is simply the amount of money which the purchaser would have needed to make the purchase on a cash basis. It is the amount of cash he would have to borrow if he wanted to pay the vendor in full. It is the portion of the purchase price which the seller must wait for. In practice, the credit needed may be assumed to be the difference between the cash price of the product and the amount of the downpayment required when it is sold on the installment plan, for it may be assumed that the buyer already has the amount of the downpayment.

The credit required is easily confused with the original unpaid balance when the credit charge is added to the purchase price in the original entry on the creditor's books. By no stretch of the imagination, however, can it be reasoned that the charge is part of the credit extended. While it may be part of the sum due from the debtor, the debtor was not financed for the charge in the purchase of the commodity. The credit needed relates to the financing of the commodity; the charge for the credit relates to the cost of that service given in addition to the commodity.

In the case illustrated above, if the customer has no money at all he obviously lacks $400, regardless of the manner in which the charge is expressed. If a downpayment of $50 is required, perhaps in the nature of an allowance on an old refrigerator, the buyer lacks only $350. This is true even in the third instance, for one could not say that he lacks $424 less $50, or $374, because the price of $424 is arbitrarily determined by the charge made, and had he had $350 more than the $50 for the downpayment, he would have made a cash purchase for $400. It is theoretically unsound to reason that the vendor extended credit for $374, for that would imply that a service charge was being made on the cost of the credit.

3. Ascertain the nominal rate of the credit charge.-The object of this step in the computation is to determine a rate of charge, unless the nominal rate is already stated in the terms of the agreement. The nominal rate is found by dividing the cost of the credit by the amount of credit used. Thus, if the $400 item were bought entirely on credit, without any downpayment or allowance on a traded-in product, and the service charge amounted to $24, the nominal rate would be 6 percent. On the other hand, if a downpayment or allowance of $50 were made, the $24 charge would be collected for extending $350 of credit; the rate would then be 6.86 percent ($24 divided by $350).

4. Compute the nominal rate per annum.-For comparative purposes rates must be related to a time period, and the most common rate period in matters of money is the year. Nominal rates, however, are not always quoted on an annual basis. It is therefore necessary to convert them to an annual rate. The general relationship may be expressed by the following equation:

Nominal rate: time involved=nominal annual rate: 1 year Another way of achieving the same result is to divide the nominal rate by the time involved (months or weeks) and multiply the quotient by the the number of such units in a year (12 or 52).

In the illustration, assuming that the contract extends for 6 months, 6.86 percent: 6 months=r: 12 months. This means that 6r equals 82.32 (6.86 times 12), and the nominal annual rate, represented by r, is 13.72 percent (82.32 divided by 6).

Strictly speaking, r should be computed on the basis of the time required to repay the credit used, and not the sum of the credit used plus the charge for the credit. To make the error of including the latter gives the effect of using the credit for a longer period than was actually the case; it understates the rate charged.

5. Convert the nominal annual rate into an actual or true annual rate.-In view of the fact that the credit in use is reduced as each payment is made on

hypothesis to that effect has never been adequately verified; to the extent that it has been attempted, the verification rested on limited data of questionable validity, partly because they were in the nature of estimates many of them later changed substantially and partly on account of the short periods covered by them. As will be noted from a footnote to table 1, comparable data on consumer credit outstandings are not available for years prior to 1947. During the period covered by the data there have been four generally recognized recessions, in 1949, 1954, 1958, and 1960. In none of these recession years did consumer credit decline or otherwise change from the general pattern for the other years, either in absolute amounts or as a percent of disposable personal income, hence completely lacking in cyclical fluctuation. This is also readily discernible from figure 9.

SECULAR TREND IN CONSUMER CREDIT

In modern times, beginning with 1947, as shown in table I and figure 9, the secular or long-term trend of consumer credit as measured by outstandings has been steadily upward. Noninstallment credit outstandings have increased from 2.5 percent of disposable personal income to nearly 3.4 percent in 1960, an increase of a little over one-third in a period of 14 years. This moderate increase has been slow and steady, despite the great efforts made through the use of universal credit cards and other devices to accelerate the growth in the use of such credit, for reasons suggested in a later chapter.

Installment credit outstandings, on the other hand, increased substantially, from about 3.2 percent of disposable personal income in 1947 (when durable goods were still scarce and only 35 percent of new and used automobiles were sold on installment credit as against about 60 percent in more recent years) to about 11.5 percent on a comparable basis that would exclude Alaska and Hawaii from the published figures. This is an increase of more than 260 percent.

Notwithstanding the advantages of installment selling in meeting consumer wants, building business volume for the vendor, and otherwise benefiting the economy, some potent arguments have been advanced against it from the standpoint of individual users and the economy as a whole. Those who use installment credit generally favor it; critics and opponents often have not used it successfully or are ideologically allergic to it.

Promotes extravagance

Among the most common criticisms of installment credit are: first, that it induces the purchase of luxuries by people who can afford only necessities; second, that it causes the mortgaging of future income; and third, that it leads to overspending, whether the purchases involve luxuries or necessities.

Even advocates of this argument cannot satisfactorily distinguish necessities from luxuries. This distinction lies not in the commodities themselves but in the importance of the goods to an individual's means or standard of living. Luxuries of one person are necessities of another; and luxuries of yesteryear are necessities of today. Bathrooms, hot water, telephones, electricity, central heating, and many articles commonly used today, such as pianos, radios, television sets, washing machines, ironers, toasters, and the like, are now necessary "luxuries." Their availability on installment credit has encouraged not extravagance but the desire for a higher standard of living.

This wider use of comforts and conveniences does not always represent a freezing commitment of future income or overconsumption. Such a belief presumes a static future income. To the extent that increases are anticipated, adjustments can be made in the pattern of future expenditures, or other resources can be drawn upon, the increase of installment sales can scarcely be viewed as an extravagance dangerous to our economic well-being.

Hampers thrift

The installment plan is also criticized because it is supposed to exercise a detrimental effect on thrift and savings. That this is not the case will be revealed from an examination of statistics on savings, life insurance in force, deposits, and similar data reflecting thrift.

Installment credit is costly

Exorbitant charges and misrepresentation

First, it is important that rates of charge on installment transactions should not be confused with interest rates charged for the mere use of money,1 since the part for the total charge for the use of money is much smaller than the remainder of the charge which is made largely for service connected with credit granting, recordingkeeping, and collections. Stated in another way, the cost of money to the installment credit grantor, both explicit and imputed, even in the broad terms explained in footnote 3, is seldom over one-third of his total cost of such an operation.

1 Even what is normally regarded as interest for the mere use of money actually consists of three parts. One is what the economist treats as pure interest in terms of rent paid for the use of capital in which no risk or expense is involved. Another is payment for the risk assumed through possible loss of principal. A third part is in the nature of a reimbursement for management expenses incurred in making and servicing an ordinary loan that is repayable in a lump sum and a net profit on the transaction.

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