How is the collection of defaulted loans allocated between principal and interest?
The main rule of the system is that payments are always received and used to cover interest before principal. This is also the main rule even if a loan defaults. However, if it is defaulted and there is a significant likelihood that the entire loan will not be recovered, FundingPartner will prioritise covering the principal before interest as this is better for the investors, and worse for FundingPartner.
Some investors have raised questions about whether it would be better for investors if interest were always prioritised first, since one cannot deduct lost interest, but one will be able to deduct a potential loss on the principal, and therefore it would be beneficial for investors if interest were prioritised. This is not correct
In summary: It is most profitable for you as an investor that repayments are applied to the principal. This is due to both how the tax system operates and the fact that FundingPartner's platform fee is deducted at a percentage point against interest, whereas for amounts applied to the principal, investors receive the full amount.
Why does this matter and how is the calculation done?
Interest income is taxable, while losses on principal are deductible. Lost interest income is not deductible. At the same time, FundingPartner charges a platform fee as a percentage of the interest income for its service. This means that how the repayment is distributed – as interest or principal – affects both what you have to pay in tax and what you actually receive.
Let's take a closer look at two different scenarios.
Assumptions
- Outstanding principal: 100
- Outstanding interest: 100
- Interest rate: 10 %
- Platform fee: 1%
- Net interest rate to investor: 9 %
- Tax rate on interest income: 22%
- Amount collected: 100
Scenario 1: Repayment is applied to interest only, resulting in 92.2%
If the entire amount (100 kr) is considered as interest income:
- You will receive a payment of 90 kr (FundingPartner will receive 10 kr).
- You pay 22% tax on 90 kr = 19.80 kr in tax.
- You can deduct NOK 100 in lost principal, which results in a NOK 22 tax deduction.
The result is that you are left with NOK 92.2 = NOK 90 in interest income + NOK 22 in tax deductions – NOK 19.8 paid in tax.
Scenario 2: Repayment is considered as principal, then the result is 100%
If the entire collected amount of 100 kr is recorded as repayment of principal, you retain the full amount yourself = 100 kr.
Conclusion: The principal amount is best
Although losses on principal are deductible, it is more profitable for the repayment to be recorded as repayment of principal. This is because you avoid paying tax on the collected amount, and the platform fee for interest income from FundingPartners.
In a hypothetical scenario where FundingPartner did not have a platform fee, one would be left with the same amount in both scenarios.
This is why FundingPartner leads to the repayment of defaulted loans as the repayment of principal, where possible, to ensure the best possible net payout to you as an investor.