Internal Rates of Returns
The following table summarises the inputs and assumptions required for the calculation of various internal rates of return for different purposes. There are three broad types of return required of a loan portfolio:
- Comparison Rate: the National Consumer Credit Code average rate of interest including upfront, on-going and exit fees, excluding government charges, over the contractual life of the instrument. It includes future rate reductions;
- Economic IRR (Internal Rate of Return): the average rate of interest including attributable fees and costs, over the expected life of the instrument and including future rate redctions
- EIR (Effective Interest Rate): the AABS 9 average rate of interest including attributable upfront fees and costs over the expected life of the instrument excluding future rate reductions.
| Inputs and scope | Economic Internal Rate of Return | NCCP Comparison Rate | AASB 9 Effective Interest Rate |
|---|---|---|---|
| Loan principal | Included | Included | Included |
| Rate reductions | Included | Included | Excluded |
| Origination costs | Optional | Excluded | Included, if attributable |
| Recurring fees | Included | Included | Included, if attributable |
| Upfront fees | Included | Included | Included, if attributable |
| Government charges | Included | Excluded | Included, if attributable |
| Loan tenor | Behavioural | Contractual | Behavioural |
| Anticipated prepayments | Included | Excluded | Included |
| Offset accounts | Included | Excluded | Included |
The regulatory requirement for the calculation of comparison rates is the following formula:
In this formula:
- the left hand side is discounted sum of the principal amounts of credit extended to the customer;
- the right hand side is the discounted sum of fees and repayments received from the customer;
- the discount sum is from commencement of the facility at time 0, to contractual maturity T;
- r is the interest rate, the comparison rate, and is unknown.
The challenge for the provider of credit is to derive the comparison rate (r) such that the left hand side and the right hand side are equal. However, although there is a single rate of interest which equats the left and right side, it is not always easy to solve.
Example Calculation
The implied cashflow vector, note the net principal payment at origination and the sequence of repayments have the opposite signs:
The implied comparison rate is