The new rules on how interest is calculated in banking transactions are explained in detail below. You can also consult the accompanying infographic (video and printable version) and Memo for the customer for more information.
- Compound interest
- Compound interest is forbidden
- Interest on current accounts
- The new rules: changes the customer can expect
Compound interest is the calculation of the interest on interest that has already accrued on a sum of money that is owed.
The interest accrued is converted into capital (in technical jargon we say it is 'capitalized'), that is, it is added to the sum of money owed, which in turn produces more interest. When this happens, we are talking about compound interest.
Let's look at an example.
On 1 January the customer owes the bank €1,000 (principal) on which interest accrues during the year at an annual rate of 1 per cent.
|Date||Principal||Interest Rate||Months||Interest||Amount owed|
|1 January 2017||1,000|
|31 December 2017||1,000||1%||12||10||1,010|
On 31 December the customer will owe €1,010: €10 of interest + €1,000 of initial principal.
At the start of the next year the €10 in interest is added to the principal.
Provided that contractual conditions do not change, at the end of the following year the customer's debt will generate €10.10 in interest: the additional €0.10 is the interest accrued on the €10 in interest added to the principal at the end of the preceding year.
The customer's total debt has therefore risen to €1,020.10.
|Date||Principal||Interest Rate||Months||Interest||Amount owed|
|1 January 2017||1,000|
|31 December 2017||1,000||1%||12||10||1,010.00|
|1 January 2018||1,010|
|31 December 2018||1,010||1%||12||10.10||1,020.10|
It is important to understand what compound interest is and it is even more important to understand that the new rules forbid any compound interest owed by the customer to the bank.
The existing rules on late payment interest, namely the interest owed if the customer fails to make payment by the contractual due date (e.g. in the event of failure to pay an instalment on a mortgage or other loan), remain the same. The agreement terms and conditions and the Civil Code rules will continue to apply to the calculation and payment of such interest.
In addition to depositing funds in their current accounts, customers can make flexible use of credit extended by the bank (overdraft facility or line of credit.)
Therefore when we talk about interest, we are referring to both interest earned, i.e. that owed to the customer on sums deposited (the positive balance), and interest owed, i.e. that owed by the customer on funds made available by the bank.For these banking transactions - tied to a current account - the generation of interest is subject to new, specific rules as explained below.
1. How interest is calculated and when it must be paid
Keep in mind these simple rules:
- Rule 1. Accrued interest owed cannot generate other interest.
- Rule 2. Both interest owed and earned must be calculated with the same frequency, i.e. over the same period of time. This rule was true in the past as well.
- Rule 3. The period for calculating interest cannot be less than one year and the reference date for the calculation is 31 December of each year. This means that to calculate interest owed the reference period cannot be three months, for example. However, for interest earned, the agreement can provide for a period shorter than one year if it is to the customer's advantage.
- Rule 4. Interest owed is calculated at 31 December for agreements signed during the year and, in any case, on the closing of the account.
- Rule 5. Interest owed calculated at 31 December is not due on that date, but rather on 1 March of the year following that in which it accrued.
If the customer wants to maintain an account with the bank, the interest calculated at 31 December must be paid on 1 March of the following year. Banks and intermediaries must send a statement setting out the interest to customers at least 30 days before it is due (1 March).
Every year the customer has a period of time in which to choose what to do but nonetheless must make a choice (see further on, How interest owed is paid).
Existing current accounts must comply with the new rules and therefore it is very important to carefully read everything the bank sends (see further on, How the contract must be modified).
From 2017 onward all current account holders - including those who currently do not owe interest - should consider the best way of paying any interest owed. It is therefore important to be proactive and contact the bank to obtain all information and explanations needed.
2. How interest should be reported
Banks must report interest and principal as separate items.
This way the customer will always have a clear idea of the interest owed, which cannot generate additional interest, and the amount owed as principal, i.e. the principal debt, which does produce interest.
For account closures and lines of credit that are stipulated and exhausted in the course of the same calendar year, the interest due must be paid promptly by the customer by the date that the account is closed. The principal balance can produce interest as provided by the agreement, but no additional interest can be generated on the interest balance, which is accounted for separately.
3. How interest owed is paid
The customer has three options for paying amounts owed and remaining in good standing with the bank, thereby avoiding the negative consequences of a default (see further on, What happens when the interest owed isn't paid):
- If there are sufficient funds, the interest owed can be paid immediately, in cash or through a credit transfer from another account, thereby avoiding any capitalization and any increase in the debt
- It can be extinguished by setting up a direct debit; in this way the interest owed is added to the principal owed and is no longer distinct from it and is either paid out of any positive balance on 1 March, or, in the case of a negative account balance, by increasing the loan amount
- A specific provision can be added to the contract with the bank providing that amounts deposited in the account (e.g. incoming transfers) are to be used to pay interest owed. Check what the contract says on this.
At the beginning of each year, in the interval between the calculation and the payment of the interest (31 December - 1 March of the following year), the customer can take advantage of a 'grace period' in which the bank cannot collect on its credit and no interest accrues on the amount owed.
This gives the customer time to consider the best way to extinguish the debt, taking into account all possible expenses as well as any income and any funds available in other accounts. Take full advantage of this opportunity.
Customers should devote time and care to making this assessment by monitoring and planning their finances so that they can make informed decisions.
4. Direct debits: a little more information
What happens when the customer authorizes direct debiting?
The customer agrees to pay the interest by 'merging' it with the principal.
In the event the account balance is positive and is equal to or greater than the amount of interest owed, the interest is paid out of this balance, which is reduced (even to zero) by the amount of the corresponding interest due.
If the account balance is negative, starting 1 March the interest is added to the principal (i.e., it is 'transformed' into principal) and in turn generates interest. The initial amount owed therefore increases.
Direct debits must be authorized in writing (or the digital equivalent), which can generally be provided by the customer when signing the agreement to open the account or at a later date.The customer must expressly and specifically consent to debiting and may revoke authorization at any time, provided this is done before the individual debit is made.
Many banks send their customers a form to be signed and returned that provides general authorization to debit their accounts for any interest owed (see further on, How the contract must be modified).
Direct debiting is useful if the customer has no other way of paying interest owed since it helps avoid default. The interest is also paid on time and automatically, without the need for any action on the customer's part. Furthermore, if the account balance is negative, the interest is added to the principal and produces, from that moment on, new interest (calculation of compound interest), as we saw earlier.
Any customer wanting to take advantage of this option should contact the bank to obtain any information and explanation needed.
The customer is free to give or withhold authorization for direct debiting; this has no effect on the continuation of the relationship with the bank. The customer can make an informed decision to not grant authorization, but must remember that to avoid default, the interest owed must be paid by each due date using another method (e.g., payment in cash or using funds transferred from another bank).
Even if authorization is given, the customer can revoke it at any time, provided this is done before the individual direct debit is made.
5. What happens when the interest owed isn't paid
Any customer that has not authorized by 1 March direct debiting of interest or has not otherwise paid interest owed (see above, How interest owed is paid) is considered to be in default.
What are the consequences?
The lender bank can initiate legal action to recover the amount and if it reports the customer's debt status to the Central Credit Register, it must also report any unpaid interest.
In anticipation of problems that could arise during the initial implementation phase of the new rules and to protect customers that have not authorized direct debiting and have not otherwise paid amounts owed on time, for all of 2017 banks must report interest as if direct debiting had been authorized, so that no payment is missed if the account balance is positive by an amount equal to or greater than the amount of interest owed.
The suspension of the Central Credit Register reporting obligation is temporary. Starting in 2018, the Central Credit Register will report missed interest payments, even if there are sufficient funds in the customer's account, if direct debiting has not been authorized and the interest due has not been otherwise paid.
6. How the contract must be modified
The new rules apply to interest accrued starting 1 October 2016. Banks must include the new provisions in agreements stipulated as from 1 October 2016 and must modify existing agreements signed prior to that date.
According to the general principle of banking transparency, individual agreements, whether existing or new, can contain exceptions only if they are to the customer's advantage.
It is important to check how the bank has modified the applicable contract provisions with respect to the calculation and payment of interest earned, which constitutes income for customers with positive account balances.
For the payment of earned interest accrued, the agreement may provide that the sum is automatically credited to the account and is therefore capitalized and generates additional interest to the customer's benefit.
Banks can modify existing agreements using the unilateral modification option under the Consolidated Law on Banking because compliance with the new rules constitutes 'justifiable grounds' for amending an agreement.
In practice, banks have communicated with customers to outline changes to the provisions on the calculation and payment of interest, explaining the reasons for these changes, and asking them to fill out a form authorizing the banks to directly debit the account for any future interest owed (accrued, for example, on the sum used to cover overdrafts).
These modifications take effect as of the date indicated in the notice, but the customer has the right to terminate the agreement at no cost rather than accept the new terms and conditions.
The customer must expressly and specifically approve clauses providing for prior authorization to debit accounts for interest owed, as well as the written authorization itself.
Therefore unilateral modification cannot be used to add the clauses to existing agreements.
If the agreement does not allow for the unilateral modification of terms and conditions, and therefore the procedure cannot be used, the customer's express consent must be obtained both for clauses regarding direct debiting and the calculation of interest.