Payment allocation methods – Fair if disclosed? Apparently not.

    Regulation Z does not require disclosure of payment allocation methods used for open-end credit plans. Payment allocation methods can affect various aspects of the plan and may differ depending on their purpose (e.g., late payment fee assessment, release of a security interest). But allocation methods most directly affect the cost of credit when the account has two or more categories of transactions subject to different terms – usually rates and/or grace periods, as is typical of accounts that permit purchase and cash transactions. And at least one court has found that in the absence of disclosure of the payment allocation method, payments should be allocated between purchase and cash balances in accordance with the consumer’s reasonable expectation. To avoid this result, credit agreements may disclose that payments generally will be allocated at the creditor’s discretion.

    As balance transfers and other promotional offers that create balances subject to lower rates have become more common, however, creditors have been guided by best practices to disclose methods that allocate payments first to lower rates and then to higher rates. See, e.g., OCC Advisory Letter 2004-10. The OCC’s guidance cautioned national banks that they could be engaging in unfair practices if they failed to disclose any material limitations on the applicability of the promotional rate, including, if applicable, that payments will be allocated to promotional rate balances first. This allocation method could deprive the consumer of the full benefit of the promotion by imposing more finance charges than would have been imposed had payments been allocated to higher rate balances first. And so the industry standard for a number of years now has been disclosure of the method if payments will be allocated first to promotional (lower rate) balances.

    The new credit card practices rules (Regulation AA) reflect a different view of the payment allocation issue – a view that considers disclosure insufficient – unfair, in fact, if the consumer makes a larger payment than the minimum required. Under the new rules, when different rates apply to different balances on a consumer credit card account, the issuer must allocate any amount paid by the consumer in excess of the required minimum periodic payment among the balances using one of two methods: (i) high-to-low – allocate the excess first to the balance with the highest rate and any remaining excess to the other balances in descending order based on applicable rate, or (ii) pro-rata method – allocate the excess among the balances in the same proportion as each balance bears to the total balance. The creditor may vary the method by account and billing period. 74 Fed. Reg. 5498 (Jan. 29, 2009); 12 C.F.R. § 227.23.

    This new payment allocation rule raises several issues for consideration. Amended Regulation Z still will not require creditors to disclose payment allocation methods, but best practices still will dictate disclosure of any low-to-high method used for required minimum payments. And this may be the method the consumer would choose, or reasonably expect for excess payments as well, if the promotional balance is subject to a deferred interest plan. The new rule, on the other hand, will require consumers to pay the total account balance, not just the promotional balance, to obtain the benefit of any deferred interest plan.

    Creditors will need to explore options and pick the course that takes them in the right direction for their programs and consumers as they map out compliance with the new rules. Consider whether and how the rule triggers may be avoided. Consider whether and what to disclose. Consider how to provide for flexibility. Consider how best to serve consumers while arriving at the desired business goals. There may be some interesting views along less trodden paths.

    • Judy Scheiderer and Margaret Stolar