Harmonisation of Cost Elements of the Annual Percentage Rate of Charge, APR

Project No.: AO-2600/97/000169

presented by

Prof. Dr. jur. Udo Reifner
in collaboration with
Marcus Wüst (Dipl.-Math.)
Leo Haidar (Leeds, UK)
Carole Bonhomme (Reims, France)

Hamburg, 17th March 1998

Executive Summary

1. Regarding the existing harmonisation of the APR cost elements in the Member States the law in all countries mainly refers to the Directive using its wording and its exemptions. A minimum standard of APR squarelosure has been reached Europe-wide. Although there are quite important differences in the cost structure of consumer credit contracts (1) these differences are mostly not specific for one country, even occurring between different offers inside the same country and (2) there seems to be a consensus in practice among providers about a minimum standard. Accordingly, in all Member States all payments concerning services which are directly connected to the credit are included. Such services concern:

   • interest;

   • administration fees; and

   • brokers’ fees.

   As to all other fees the practice assumes that the exemptions of the Directive apply. Consequently the following cost elements are not included:

   • insurance fees irrespective of the purpose of the insurance;

   • fees for bank accounts and cards; and

   • notary fees and postage.

2. There are three services to which the Directive seems to be applied differently in Member States:

   • Endowment life insurance credit where, despite the fact that the consumer has no choice and is obliged by the contract itself to take the hidden payment protection insurance  - Germany and the UK seem to exclude such premiums irrespective of the form of its appearance. This seems to be in clear contradiction to the Directive. But it has to be stated that such products although wide spread in mortgage loans are not common in consumer credit as defined in the Directive. Further, more endowment life insurance credit as consumer credit has been ruled by German courts to be a misleading product leading to compensatory damages being awarded to a consumer if she can prove there were less costly products available on the market.  Accordingly the practical importance of such products in consumer credit is minimal.

   • Austria, France but also Greece are countries where taxes are imposed for the extension of credit, but they treat it differently with respect to APR. In the author’s view, the Directive treats such costs as „costs of the credit“ because they are inseparably linked to the credit and make a product comparatively more expensive, without offering additional services - if this product is purchased in a country where such extra charges are imposed. So the purpose of the Directive - to make offers comparable in different Member States - is not met if such specific charges are not included. But again, the amount of the taxes are not so important that major effects from this exclusion can be expected on the market.

   • The finance charge for financing Payment Protection Insurance premiums is where such financing is common like in Germany, the UK, Scandinavia (but not in France) mostly counted as part of the credit cost, but by some banks it remains outside. Even if as it will be argued later most countries in practice exclude PPI premiums from the APR because they assume that it is „non obligatory“ this is certainly not the case for finance charges which are obligatory and specific for insurance products. Those banks at least which omit the cost seem clearly to contravene the Directive, as well as national law.

3. The above mentioned differences would, with regard to the standards in all Member States, have been eliminated by the courts if those courts were to have sufficient chances to monitor the application of the Directive. In fact, all countries provide little or no case law on this matter which has to do with a lack of effective sanctions and too little financial incentive for a consumer to sue a creditor on the grounds of APR squarelosure.

4. The purpose of the Directive is not only harmonisation but also consumer protection. The goal of the APR squarelosure rules may be defined as follows:

   • Transparency for consumers to compare different credit products available on the market in order to exercise a rational choice  for the best and most cost efficient product; and

   In fact most national legislation also attribute a second goal to APR squarelosure a goal that is at least also referred to in the motivation of the second consumer credit Directive:

   • Disclosure of especially high costs in consumer credit burdening low-income consumers with respect to their poor bargaining power, in order to stigmatise such providers and, for some countries, to apply legal remedies deriving from rate ceilings and usury legislation.

5. In the context of a high standard of consumer protection as well as in the context of the effective achievement of the purpose of the regulation the factual situation in the Member States is still unsatisfactory. In practice up to 30% of standard costs a consumer will pay in a consumer credit agreement are not represented in the APR. The exemptions in the Directive concerning some linked products like insurance and bank account fees have led to their total exclusion. The sophisticated restrictions on the application of these exemptions in the Directive itself have no practical effect. Accordingly, this regulation has failed to achieve its goals. The effects of this situation are visible in the following phenomena:

   • Payment Protection Insurance has developed into a general outsourcing of credit risks at the cost of the consumer. The products are disadvantageous, extremely costly and applied inappropriately and to that extent, far too often. It seems as if the provisions paid to the banks for the extension of insurance products have become a main source of additional income for credit providers, escaping competitive forces;

     Specifically charged bank account fees are not yet an economic problem but with the spread of credit card credit - which is no longer linked to overdraft credit on a current account but provides own credit facilities - increasingly fees concerning credit are allocated with payment devices and thus escape APR-legislation;

   • Combined, endowment products which divert repayments of the credit into a form of savings agreement with lower interest returns in the savings than is charged in the credit are increasing. Products like „endowment capital life credit“, „secured credit cards“, instalment or overdraft credit where assets are requested as a security are already on the market, undermining transparency and rational choice as well as usury legislation.

   • Zero interest credit is extended by banks owned by automobile companies as an incentive to buy cars. In fact such low interest rates are often paid partly by a denial of squareounts that ordinary cash purchasers get.

6. The single mathematical formula is effectively harmonising the way of APR calculation in those countries where they have been already prescribed when the study was conducted. (all but Germany, France and Finland) The recalculation of the APRs showed no mathematical deviations. All deviations stemmed only from the inclusion or exclusion of additional cost elements. There are therefore no mathematical arguments which may be raised for the inclusion or exclusion of connected services and costs. The mathematical formula, where K₁ = K₀ * (1 + i)^t is sufficient to calculate all kinds of credit and other services - with the help of spreadsheet software and iterations - if  the payments of the consumer and the provider as well as the time when these payments are effected (payment flow calculation) are known. Sophisticated formulae are unnecessary and mostly only applicable to specific standardised credit contracts, tending to hide normative assumptions in mathematical language. The trend towards individualised products necessitates payment flow calculations where each single payment may be defined separately, excluding all kinds of mathematical formulae.

7. Most national legislation fail to clarify the question concerning the link between a cost element appearing in a credit contract and the credit cost itself. National legislation understands the Directive as follows:

   • Some national legislation use a cash flow definition other a cost element definition.  Indeed Art. 1 uses a concept of credit prices as „cost“ elements. Art. 1a which was incorporated into the original Directive in order to implement the unique mathematical correct formula refers to all the payments made within a credit relationship. The first definition was adequate as long as linear formulas were in use wherein the APR was calculated on the basis of a comparison between cost to time and net capital alone. Introducing the compounding period into the calculation modern and correct mathematical procedures require to monitor all payments between creditor and borrower irrespective which part of the credit (repayment of the principal or payment of cost or fees) is concerned. The old definition in Art.1 has become obsolete because it is mathematically not operational. The definition in Art.1a is instead sufficient and clear.

   • In the light of the definition in Art. 1a the question of the inclusion of cost elements into the APR calculation has shifted from the statement which cost elements have been paid „for the credit“ to the question which payments are linked to the exchange between creditor and borrower. In fact the core question is which services provided together with the extension of the consumer credit are „linked“ to the credit contract so that their payments have to be incorporated into the APR calculation. National legislators have not given any clear definition of which services have to be seen as „linked“ to a credit in such that their payment flow should be incorporated into the calculation of the APR of the credit. In fact the Directive is partly understood as supporting a mere legal view in which the legal obligation to contract additional services is the only criteria for its inclusion while other national legislation seems to further a more economic view in which economic constraints suffice to qualify additional services as linked services.

   • The Directive uses several examples to clarify its view of linked services:

     • Some products are especially named like insurance, bank accounts while other examples concern a more general structure (cash versus credit) or language („cost of the credit“);

     • In some places, economic language („cost of the credit, reasonable freedom of choice“, „abnormally high“) is used to ensure that as stated in Art. 14, the „Directive is not circumvented as a result of the way in which agreements are formulated“ while in other parts legal language („commitments“; „imposed by the creditor“; „obliged to pay“) is used. This is interpreted by national legislators as giving providers the opportunity to „define“ in the contract whether  there are links or not irrespective of the economic constraints and the fact that such products are especially designed for credit contracts;

     • The Directive apparently only regulates exemptions. But most of the text of the exemptions concerns „exemptions of exemptions“ and could, in the tradition of transparent legislation, be regulated as positive examples instead of double-negative exemptions. A formulation of positive examples would perhaps leave less space for the obvious desire of most suppliers to take the exemptions as the only part of the law  with whom they have to comply. Turning exemptions into examples would instead focus national legislation on the general principle of links between credit and credit related services which should be represented by one unique APR.

8. In light of the requirements of consumer protection, national legislation and the practical enforcement of the Directive seems to be insufficient. This could either be remedied by additional action of the EU Commission to further national regulations which are more reflecting the spirit of the present Directive. But also a shortening and clarification of the wording of the Directive could support such developments. The report formulates a new Art. 1 letter d  and a new letter e on „linked transactions“ as well as a number of examples given in Annex 4 replacing the given Art. 1a of the Directive. Its main intention is

   • to use solely the APR definition of Art. 1a

   • the insertion of a general definition of “linked transactions” which is similar to the approach already used in Art. 11 of the Directive to safeguard consumer rights in linked transactions of purchases and credit. This definition has to include the criteria as well as the indicators of services whose payment flow will be included into APR calculation;

   • to replace the exemptions by a list of positive and negative examples in the Annex which force the national rule making bodies and the banks to focus on the general principles instead of formal aspects which are easier to fulfil in order to escape the inclusion of such linked services;

   • to separate general definitions of linked services from the definition of products which are seen as examples of linked or unlinked services.

9. Besides the report proposes that Consumer Organisations in Member States should be equipped with a computer programme that provides input facilities and explanation for all cost items to be included, combines them into a correctly calculated Annual Percentage Rate of Charge and stores the credit data used for such calculations for later evaluation in order to monitor the practical application of the Directive in all Member States where presently monitoring seems to be insufficient.