Lesson 12 of 25 · 6 min
Why the use of proceeds changes the treatment of the cost
One account holding two kinds of money creates a third problem: an ordering rule nobody chose decides the answer.
Once borrowed money and other money sit in the same account, the question of which dollars were spent has no factual answer. A rule supplies one.
The rules that do this are ordering rules. They deem spending, or repayment, to apply to categories in a fixed sequence regardless of what anyone intended or recorded. They exist because the alternative is unadministrable, and they are indifferent to the outcome they produce in any individual case.
Repayment is where the ordering bites hardest. Suppose $600,000 is outstanding, traced $260,000 to income-producing use and $340,000 to personal use, and you repay $200,000. Under an ordering rule that applies repayments to the income-producing portion first, the balance becomes $60,000 and $340,000. At an assumed 7.1 percent, interest on the income-producing portion falls from $260,000 × 0.071 = $18,460 to $60,000 × 0.071 = $4,260, a fall of 76.9 percent, while the personal portion stays at $24,140.
A third of the balance was repaid and more than three quarters of one category disappeared. None of that was a choice. The same repayment under a different ordering would have left the two categories in a completely different state.
An ordering rule turns an accounting question with no answer into an answer with no accounting. The allocation is settled before the money moves.
Whether an ordering rule of this shape reaches a particular arrangement, and which sequence it uses, is a question for the holder's own adviser working from their own records.
Key terms
- Ordering rule
- A rule that deems spending or repayment to apply to categories in a fixed sequence, because the underlying facts cannot distinguish them.
- Category
- A portion of one balance characterised by what it funded. A single loan can hold several, and they behave separately.
Worked example
A repayment that chose its own target
A $600,000 balance traced $260,000 to income-producing use and $340,000 to personal use. You repay $200,000. The 7.1 percent is an assumption of the example.
- Income-producing portion before repayment
- $260,000
- Personal portion before repayment
- $340,000
- Repayment applied under the ordering rule
- $200,000
- Income-producing portion after
- $60,000
- Fall in that category of interest
- 76.9%
Interest of $18,460 at 7.1 percent.
Interest of $24,140.
To the income-producing portion first.
Interest of $4,260.
($18,460 − $4,260) ÷ $18,460.
Repaying a third of the balance removed more than three quarters of one category, and the borrower selected neither proportion.
Check yourself
A $600,000 balance is traced $260,000 to income-producing use and $340,000 to personal use. A $200,000 repayment is applied to the income-producing portion first. What happens to each category of interest at an assumed 7.1 percent?
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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.