Interest calculation scam–watch out for this one! (long) - Posted by Eduardo (OR)
Posted by Eduardo (OR) on March 21, 2000 at 13:54:10:
Yesterday, on this forum, one of the respondents was advising readers to use a “home-made” method of computing interest-only payments on appropriate real estate transactions where, in the example used, an interest rate of 2.35% would be disguised to look like a rate of 7%. In other words, the other party to the transaction would be told they are getting 7% when in reality they would only be receiving 2.35%. Do not do this sort of thing! It can open one up to a huge lawsuit and there is not a court in the country that would not come down on the side of mom and pop against this kind of scam.
The entire lending industry (mortgage lenders of all kinds from banks on down) in this country are governed by the federal Truth-in-Lending Act passed in 1968. Regulation Z of that act “requires the computation of the effective loan yield (cost) on a given loan according to an actuarial method prescribed by the act.” (Hoagland, et al. Real Estate Finance.) There are certain prescribed methods of computing interest which must be adhered to by the lending industry and disclosed to the borrower. These methods must be used by every industry from mortgage lending to automobile financing (and the choice of method to be used may vary from industry to industry, but essentially results in the same amount to be repaid by the borrower). In real estate lending an annual percentage rate is negotiated between the parties and the amount of interest to be paid is calculated according to Reg. Z methods that are the same whether the loan is fully-amortized, partially-amortized, or interest-only. In the U.S. mortgage lending industry, if the agreed upon rate is, say, 7% per annum and the payments are to be made monthly, then there is one way, and one way only, in current use to compute or calculate the amount of that monthly payment. By law, the calculation of the annual percentage rate (APR) must be in compliance with Reg. Z and that APR must be disclosed to the borrower.
Where does this leave individual private parties such as real estate investors who are working directly with buyers and sellers and may be involved in private financing such as seller carryback mortgages? Most investors follow the lead of the lending industry, as well they should. All financial calculators are programmed to return solutions consistent with Reg. Z requirements in their cash-flow registers and recommended time-value-of-money calculations.
No problem if you follow the directions in the manual provided for working real estate loan problems. Just do it the lending industry does, the way the financial calculators are set up to do it, and the way taught in the nation’s business schools (see, for example, Simpson, et al. Mathematics of Finance or Cissell, et al. Mathematics of Finance). Most private parties calculate mortgage loans the correct way, whether they know it or not. A stated (nominal) 7% per annum loan means someone is going to receive a return of 7% on their money or close to it (it depends on the number of payment and compounding periods per year–these can vary and result in what is known as the effective rate of return [that, for purposes of our discussion, whether the money is compounded annually or continuously or something in between, won’t vary much from 7%]).
The problem here comes when someone uses, either through ignorance or design in trying to further their real estate investing career, a “home-made” method computing interest that results in a “significant” difference in return from the stated rate on the contract to the actual amount received. If you tell someone they are getting 7% on their money when in reality they are only receiving 2% or 3% return, or if you write 7% on the earnest money agreement, the loan documents, or a table napkin, and write in a payment that, if analyzed, would show that they are in fact not receiving 7%, but some lesser rate of interest according to industry standards and common practice, and the other party relies on this, then you may be guilty of fraud. Do not do this, do not allow yourself to be tempted to do this. It is too easy to catch and there are too many legitimate ways to make money in this business. Sorry for the long post, had to get this off my chest. Hope I havn’t offended anyone (other than guilty parties). --Eduardo
P.S. Whenever someone presents you with figures on a real estate deal, always redo the computations yourself. I’ve seen professionals from lenders to lawyers make mistakes of the kind discussed above to say nothing of real estate agents and other investors.