Managing the Risk of Paid Ahead Loans
The compliance team is often asked whether there is a federal regulation that limits the number of days a loan can be paid ahead. While there is no federal regulatory limit on how far in advance a loan can be paid, there are a few risk management practices and contractual limitations the credit union may want to consider.
To begin with, the credit union's loan agreement with the member may govern how payments are applied to the loan. For example, there may be a clause in the agreement regarding how payments in excess of the principal, interest and escrow (if any) will be applied such as advancing the due date or paying down the principal. Generally, ambiguities in a contract are left to state law interpretation so it is important to ensure contract clauses regarding the application of payments are clear. If the credit agreement is silent on the matter, the manner in which the credit union applies excess payments may come down to internal policies or even case law which may not be ideal as courts may interpret things differently yielding various results. If the credit union permits the due date to advance, here are some risk management principles to note.
There are several instances in which NCUA references paid ahead loans as part of a credit union's overall risk management strategy. For instance, transaction risk is defined in NCUA's Examiner's Guide, Chapter 1 as follows:
The risk to earnings or capital arising from fraud or error that results in an inability to deliver products or services, maintain a competitive position, and manage information. This risk (also referred to as operating or fraud risk) is a function of internal controls, information systems, employee integrity, and operating processes. This risk arises on a daily basis in all credit unions as they process transactions.
Paid ahead loans may affect a credit union's transaction risk because some members that obtain a loan may subsequently make large loan payments in excess of the required monthly payment to advance their due dates and skip town—potentially defrauding the credit union. Maintaining some level of contact with these paid ahead members may be necessary to manage transaction risk and ensure the member or the collateral does not do a Houdini disappearance trick. This is not to say that perfectly legitimate reasons why members may pay more to advance their due dates do not exists. For example, a member may be planning to go backpacking through Europe or simply decide to pay more to get ahead of their debts. So a couple of things to note is how far in advance a member seeking to advance their due date and whether the member has a legitimate reason to pay ahead.
Paid Ahead Loans report - Identifies loans with advanced due dates.
When reviewing this report, the examiner should compare the borrower’s actual payments over time to the note’s required payment schedule. If discrepancies exist, the examiner should review a sample of related loan files, being especially cognizant of paid ahead loans where staff performs frequent file maintenance changes or where the prior activity date is long past (may be a deficiency balance that the credit union failed to charge off). Since a payment is due every month on open-end loans, they should not appear on the paid ahead report. Most IS reports flag open end loans so they do not appear on this report; however, the credit union may not have implemented this feature.
Transaction risk. Numerous transaction risks accompany lending. The strength of the credit union’s internal controls will determine the extent of the risk. Management may demonstrate their control of transaction risk through reviewing internal reports such as Paid Ahead Loans, Non-Amortizing Loans, File Maintenance, Supervisory Override, Accrued Interest Greater than Payment, etc. Appendix 4B to the Internal Controls chapter of this Guide discusses other specific loan-related reports.
Finally, NCUA’s Supervisory Committee Guide also talks about paid ahead loans and states that credit unions may want to ascertain the reason a loan is paid ahead more than 60 days. Here is the relevant excerpt from Chapter 7 of the Guide:
What reports should we review as part of the audit if the credit union has an [Electronic Data Processing] EDP system?
7.16 You should review the following reports:
Negative share reports.
Unposted item reports for NSF drafts and NSF ATM transactions.
Computer file maintenance (data change) reports – focusing on loan data changes and address changes.
Loans by interest rate summary -- look for loans with unusually low interest rates.
Paid ahead loan report -- review the reason the loan is paid ahead more than 60 days.
Dormant (inactive) share account reports.
Any exception reports.
(Emphasis added.) Paid ahead loans can be difficult to manage so it is important the credit union establishes policies and procedures to ensure it is adequately mitigating its transaction risk and protecting itself from potential scams.
While some of our colleagues are celebrating NAFCU's 50th Anniversary at our Annual Conference & Solutions Expo in Hawaii, some of the fort holders in the Government Affairs team attended the Consumer Federation of America awards dinner in Washington, DC. I have to say, it was really fun catching up with local credit union folks during this event and hearing wonderful remarks about the credit union industry from other attendees. Here is a picture of Ann Kossachev, whom you may recognize from several Regulatory Alerts and previous blogs, and me.