DAVID J. WILLIS ATTORNEY
Copyright © 2013. All rights reserved worldwide.
FEDERAL REGULATION OF
"HIGHER-PRICED MORTGAGE LOANS"
Including Comments on the Impact on Owner Finance in Texas
by David J. Willis, J.D., LL.M.
Certain home loans have been defined by the Federal Reserve as being "higher-priced mortgage loans" because (in part) the annual percentage rate charged on such loans exceeds the average prime rate by 1.5% for a first lien or 3.5% for a subordinate lien. Rules in this area are particularly important in the area of owner-financed transactions since the APR is usually higher than in conventional or FHA financing. Specifically, if the loan application date is later than April 1, 2010; the loan will be a first or subordinate lien on a one-to-four family residence; the property will be owner occupied; and the APR exceeds the amounts stated above, then such a loan is now classified as a higher-priced mortgage loan and new law applies.
The Six-Month Lease Option
Lease-options are still useful devices if the term is less than six months or if the property is paid for (which means that a lender´s consent will not have to be obtained). So what about the possibility of "stacking" six-month option contracts – i.e., allowing the option to expire and then renewing it every six months? This does not violate the letter of the law; however, if long-term stacking was the intent of the parties from the beginning, it is possible that a judge will see through this method and find that the arrangement is indeed an executory contract that violates the statute. It all comes down to whether or not the buyer becomes disgruntled and decides to challenge the transaction with a lawsuit. No challenge, no issue.
Having made this observation, one should not refrain from utilizing a 180 day (or less) lease-option if it is appropriate under the circumstances to do so – particularly if there is a reasonable possibility that the option could be exercised during that period. Also, if the parties decide in good faith to renew that option for another option term, they should not hesitate to do so. In this context, we recommend using a 179 day option term just to avoid any issue about whether or not the statute has been violated.
Applicable law is Regulation Z (12 CFR Part 226), specifically Section 226.35 which is set forth in full at the end of this article. The higher-priced mortgage loan regulations are sometimes referred to as "HPML regs" and such loans are often called "Section 35 loans" or "HPML loans." Section 226.35, entitled "Prohibited Acts or Practices in Connection with Higher-Priced Mortgage Loans," became effective October 1, 2009 except for rules requiring collection of an escrow which became effective April 1, 2010.
New Federal Laws Impacting Owner Finance
The HPML regs are part of a wave of federal regulation designed to curb abuses in the owner finance industry which contributed to the accumulation of bad loans in lenders´ portfolios and the subsequent collapse of the national real estate market.
Among the new laws is Dodd-Frank, which requires that a residential seller/lender in an owner-financed transaction perform due diligence in order to determine that the buyer/borrower has the ability to repay the loan. Under Dodd-Frank, it is the seller´s obligation to investigate buyer´s credit history, current and expected income, current obligations, debt-to-income ratio, employment status, and the like in order to determine the Buyer´s ability to repay. The owner-finance note must be fixed rate or, if adjustable, may adjust after 5 or more years and must be subject to reasonable annual and lifetime caps. Balloon notes are not allowed.
Another important law is the federal S.A.F.E. Act (implemented in Texas Finance Code Ch.180 as the "Texas Secure and Fair Enforcement for Mortgage Licensing Act of 2009" or "T-S.A.F.E.") which requires that a seller/lender of one-to-four family residence in an owner-financed transaction have a residential mortgage loan origination (RMLO) license issued by the Texas Savings and Mortgage Lending Department. T-S.A.F.E. (including the RMLO requirement) applies if the owner-financed transaction (1) pertains to property other than the seller´s homestead; or (2) if the transfer is to someone who is not in the seller´s immediate family; and (3) the seller engages in more than 5 owner-financed transactions in any 12 month period.
Also noteworthy in the context of owner finance are certain recent state laws, including the requirement that the seller give both the existing lienholder and the buyer a written notice setting forth specific information about the existing lien at least 7 days prior to closing (Texas Property Code Sec. 5.016); and burdensome rules relating to contracts for deed and other executory contracts (Texas Property Code Sec. 5.061 et seq.).
Texas, formerly the wild west of seller financing (recall the practice of "red flagging" rural lots) must now follow strict guidelines.
HPML Escrow Requirement
The seller in an owner-financed transaction subject to HPML regs must establish an escrow account. Sec. 226.35(b)(3)(i) states that "a creditor may not extend a loan secured by a first lien on a principal dwelling unless an escrow account is established before consummation for payment of property taxes and premiums for mortgage-related insurance required by the creditor, such as insurance against loss of or damage to property, or against liability arising out of the ownership or use of the property, or insurance protecting the creditor against the consumer´s default or other credit loss."
Note that the regulation requires that an escrow account be established before "consummation for payment of property taxes and premiums." When does such consummation occur? The language is unclear, but it is reasonable to interpret "consummation" in this context as the shift to the buyer of the obligation to pay ad valorem taxes and insurance premiums – and this occurs at closing. At the very least, therefore, an escrow account should be established at closing.
A common practice is to provide for an escrow that commences with the first monthly payment. This would not appear to comply with Sec. 226.35(b)(3)(i) since the escrow was not established at closing – an escrow account, after all, cannot be commenced with a zero balance. As a practical matter, therefore, it may therefore be necessary to open an escrow at closing with deposit by the buyer of an initial escrow amount – even if that amount is nominal.
What if a buyer wants to terminate the required escrow? This appears to be permissible according to Sec. 226.35(b)(3)(iii) which states that a "creditor or servicer may permit a consumer to cancel the escrow account required in paragraph (b)(3)(i) of this section only in response to a consumer´s dated written request to cancel the escrow account that is received no earlier than 365 days after consummation." Must a seller/lender comply with such a request? The statute´s use of the word "may" rather "must" suggests that the seller may decline a buyer´s request to terminate the escrow.
The Role of Third-Party Servicers
The traditional Texas owner-financed transaction contemplates that the seller will receive and handle both payments of principal and interest as well as escrow. There are, however, potential problems with this approach. Will the seller report the amount of interest paid to the IRS? Will the seller have the capability of generating an escrow analysis if required? Does the seller report timely payment history to the credit bureaus? Most individual sellers are neither equipped nor inclined to perform these duties.
There is also the matter of trusting the seller on certain key items – for example, timely payment of taxes and insurance premiums. What if the seller fails to do this and instead mishandles the escrow? Another example of trust occurs in wraparound transactions, in which the buyer agrees to make payments to the seller and the seller, in turn, promises to make payments to the first lienholder. What if the seller defaults on this obligation?
A solution to these issues is to engage a third-party servicer who will collect payments from the buyer (including by electronic means) and see to it that any escrow or secondary payments are properly made. We are aware of two reputable loan servicing companies, one in Houston and the other in the Dallas/Ft. Worth area:
The higher-priced mortgage loan rules (Regulation Z - 12 CFR Part 226) are, along with the S.A.F.E. Act and Dodd Frank, part of a federal trend to impose nationwide regulations upon certain lending practices as they relate to owner finance. Texas, once the haven for easy owner finance deals, now finds itself in the same highly-regulated environment as the rest of the states. Prior to engaging in an owner-financed transaction, it is advisable to consult with a real estate attorney familiar with these matters.
Information in this article is proved for general educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well. This firm does not represent you unless and until it is retained and expressly retained in writing to do so.
Copyright © 2013 by David J. Willis. All rights reserved worldwide. David J. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his web site, http://www.LoneStarLandLaw.com
EXHIBIT: AMENDMENT TO REGULATION Z (12 CFR PART 226)
(Effective on October 1, 2009, except for (b)(3) which is effective on April 1, 2010)
§ 226.35 Prohibited Acts or Practices in Connection with Higher-Priced Mortgage Loans.
(a) Higher-priced mortgage loans.
(1) For purposes of this section, a higher-priced mortgage loan is a consumer credit transaction secured by the consumer´s principal dwelling with an annual percentage rate that exceeds the average prime offer rate for a comparable transaction as of the date the interest rate is set by 1.5 or more percentage points for loans secured by a first lien on a dwelling, or by 3.5 or more percentage points for loans secured by a subordinate lien on a dwelling.
(b) Rules for higher-priced mortgage loans. Higher-priced mortgage loans are subject to the following restrictions:
(2) "Average prime offer rate" means an annual percentage rate that is derived from average interest rates, points, and other loan pricing terms currently offered to consumers by a representative sample of creditors for mortgage transactions that have low-risk pricing characteristics. The Board publishes average prime offer rates for a broad range of types of transactions in a table updated at least weekly as well as the methodology the Board uses to derive these rates.
(3) Notwithstanding paragraph (a)(1) of this section, the term "higher-priced mortgage loan" does not include a transaction to finance the initial construction of a dwelling, a temporary or "bridge" loan with a term of twelve months or less, such as a loan to purchase a new dwelling where the consumer plans to sell a current dwelling within twelve months, a reverse-mortgage transaction subject to §226.33, or a home equity line of credit subject to §226.5b.
(1) Repayment ability.
A creditor shall not extend credit based on the value of the consumer´s collateral without regard to the consumer´s repayment ability as of consummation as provided in §226.34(a)(4).
(2) Prepayment penalties.
A loan may not include a penalty described by §226.32(d)(6) unless:
(i) The penalty is otherwise permitted by law, including §226.32(d)(7) if the loan is a mortgage transaction described in §226.32(a); and
(ii) Under the terms of the loan-
(A) The penalty will not apply after the two-year period following consummation;
(B) The penalty will not apply if the source of the prepayment funds is a refinancing by the creditor or an affiliate of the creditor; and
(C) The amount of the periodic payment of principal or interest or both may not change during the four-year period following consummation.
(i) Failure to escrow for property taxes and insurance.
Except as provided in paragraph (b)(3)(ii) of this section, a creditor may not extend a loan secured by a first lien on a principal dwelling unless an escrow account is established before consummation for payment of property taxes and premiums for mortgage-related insurance required by the creditor, such as insurance against loss of or damage to property, or against liability arising out of the ownership or use of the property, or insurance protecting the creditor against the consumer's default or other credit loss.
(ii) Exemptions for loans secured by shares in a cooperative and for certain condominium units
(A) Escrow accounts need not be established for loans secured by shares in a cooperative; and
(B) Insurance premiums described in paragraph (b)(3)(i) of this section need not be included in escrow accounts for loans secured by condominium units, where the condominium association has an obligation to the condominium unit owners to maintain a master policy insuring condominium units.
A creditor or servicer may permit a consumer to cancel the escrow account required in paragraph (b)(3)(i) of this section only in response to a consumer´s dated written request to cancel the escrow account that is received no earlier than 365 days after consummation.
(iv) Definition of escrow account. For purposes of this section, "escrow account" shall have the same meaning as in 24 CFR 3500.17(b) as amended.
(4) Evasion; open-end credit.
In connection with credit secured by a consumer's principal dwelling that does not meet the definition of open-end credit in §226.2(a)(20), a creditor shall not structure a home-secured loan as an open-end plan to evade the requirements of this section.