Interest Rate Calculations

What the law says

The amount of interest credit unions can charge is capped in the Credit Unions Act (and its later amendments) and should not exceed ‘one per cent per month, or such other rate as may from time to time be specified, on the amount of the loan outstanding and such interest shall be inclusive of all administrative and other expenses incurred in connection with the making of the loan.’  Subsequent amendments have raised the cap to 3% per calendar month as set out below.

You are also under a general obligation to ensure that the rate you charge on loans is in agreement with the rate that is advertised and is contained in the loan agreement, regardless of the interest cap.

What this means

Credit unions may charge up to the maximum interest rate that is legal for credit unions.  This is currently three per cent per month on the reducing balance as of 1 April 2014.

How to apply this to loans

There is no standard in Great Britain for the interval at which interest is applied to credit union loans.  There is no stipulation in law or regulation regarding this.  However, it is considered good practice to calculate this daily.  To arrive at the interest figure applicable for your chosen period, you take the annual interest rate i.e. the monthly rate multiplied by 12 and then divide by the unit of the period.  For example, daily interest on a loan charged at 3% pcm, is (3 x 12)/365 (or 366 for a leap year).  Weekly interest on a loan charged at 3% pcm is (3 x 12)/52.

A method for calculating daily loan interest

Interest accrued is calculated and accumulated on a daily basis using the following formula:

[Interest Accrued = (Current Loan Balance x Number of Days x Interest Rate)/(Number of interest days in the year x 100)]

In this method, interest is not compounded i.e. no interest is applied to unpaid interest due. This is not a requirement but is generally considered good practice. Total interest due therefore (where a member has unpaid interest in their account) is calculated as follows:

[Total Interest Due = Interest Accrued + Interest Arrears]

What about the APR?

The APR given on credit union loans made at one percent per calendar month is 12.7%.  The APR given on credit union loans made at two per cent per month is 26.8% for on loans made at three per cent per month is 42.6%.  This figure represents an annualised interest rate where no repayments are made.  The interest is added to the principal on a monthly basis and compounds over the year to produce the APR figure.  The APR figure should not be used as the starting figure for calculating interest as it represents a compounded interest rate i.e. interest on unpaid interest due.  Using the APR figure to calculate interest could result in members being charged more than the legal limit.  For example, taking the APR of 26.8% and dividing it by 12 brings you to a monthly figure of 2.2%.

IT packages

Most, if not all, credit unions will use an IT package to calculate interest charged on loans to members.  Generally this is an automated process.  The important thing to remember, however, is that this calculation should not start from the basis of the APR figure.  It may start from a monthly rate e.g. 1%, 2% or 3% – or an annualised rate–i.e. 12%, 24% or 36% (the monthly interest rate multiplied by 12 months, which the system will then apply to the appropriate reducing balance).It is yourresponsibilityto ensure that the IT package is producing rates which do not exceed the maximum monthly interest rate and that the amount charged isin line with the rate agreed with the member.  The calculation method above should assist you in checking that this is the case.

Responsibility of the Board of Directors

The legal responsibility for ensuring a credit union is charging interest within the legal limit sits with the Board of Directors.  It is not the responsibility of IT providers.  If your credit union uses a software package to produce its interest figures then you should contact them to check the basis of the calculation it uses to do this.  You should also look at the figures produced by your system on any loan documentation it generates.  The APR should never appear higher than 42.6%.