High Cost Mortgages: The Unsimplification of Truth in Lending

The Federal Reserve has published final rules on specialty mortgages: high cost mortgages and reverse annuity mortgages. These new rules (the result of Congressional action) add a giant step to the unsimplification of Truth in Lending and Regulation Z. High cost mortgages and reverse annuity mortgages, referred to as "certain home mortgage transactions" are a new category of loan triggering special disclosures. The no-longer simplified Regulation Z now sports these specialized rules in addition to special rules for adjustable rate mortgages, home equity lines of credit, credit card rules, and rate caps.

Read the special rules in the context of the complete regulation. These specialized rules dealing with certain loan products are presented as a specialized and distinct set of rules. However, they must be read in the context of the regulation as a whole. In particular, you should be aware of regulatory traps. For example, these special rules may contain specialized definitions and other tripwires that trigger coverage.

However other rules in the regulation, such as the residential mortgage trans-actions definition which triggers the three-day early disclosure rule, should not be confused with the rules for high cost mortgages.

Another trap is that the timing rules may differ or be in addition to the basic rules. For example, the early disclosure and waiting period for high cost mortgages does not affect the borrower's right to rescind. Therefore there are two waiting periods for a rescindable high cost mortgage: the special rule's pre-closing waiting period and the three day right to rescind which begins at closing.

The new rule on High Cost Mortgages
The regulation now contains a new Subpart E. This section, in ?226.31, lays its own rules of interpretation and guidance. Be careful to read these in the context of ?226.17. They are not instead of ?226.17; they are in addition to those rules.

What makes a mortgage a high cost mortgage?
A high cost mortgage has several key elements.

First, it must be secured by the con-sumer's principal dwelling.

Second, it must meet one of two cost measurements:

The APR at consummation will exceed by more than 10 percentage points the yield on Treasury securities having comparable periods of maturity to the loan maturity; or,
The total "points and fees" payable by the consumer at or before loan closing will exceed the greater of 8% of the loan amount or $400.

Note that the rule measures the cost by specific treasury securities, without regard to the actual index the bank is using. If your index is higher than the Treasury securities index, you need to track both indices to determine when the rule may be triggered.

Short term loans, such as 3-year balloons, can exceed the rate limitation because the total finance charge is fully accounted for in the 3-year term instead of a 30 year amortization.

Note that the points and fees used to measure whether the loan is a high cost mortgage are not the same as the finance charge. The high cost mortgage rule includes not only the "traditional" finance charge of Truth in Lending; it also includes all compensation paid to mortgage brokers and all items disclosed in ?226.4(c)(7) except taxes that are otherwise exempt from the finance charge. Remember to include these in your calculations when you are determining whether you make any high cost mortgage loans!

Fortunately, some loan transactions are exempt from this rule. Residential mortgage transactions (loans to purchase a home) are exempt from the high cost rules. Other special loans Reverse mortgages (covered by ?226.33) and home equity lines of credit are exempt from this rule. These loans are already subject to similar disclosure and timing requirements. These three loan types are exempt regardless of the finance charge on the loan.

Disclosures
Disclosures provided to consumers must contain several items of information. First, there must be a notice that the customer is not obligated merely by receiving disclosures. Second, the disclosures must contain certain numeric disclosures including the APR, and the amount of the regular payment. Third, if the loan has a variable rate feature, the disclosure must include the explanation of the variable rate.

Early disclosures
Before making a high cost mortgage, the bank must send detailed disclosures to the borrower at least three business days before consummation of the loan. Note that this requirement is separate from the rescission period which occurs after consummation. If a change in terms occurs before consummation, the bank must give new disclosures to the borrower.

Waivers
However, like rescission, there are limited situations when a consumer may waive all or part of the waiting period. Consumers may waive the waiting period only for a bona fide personal emergency. Simply wanting the transaction to go forward quickly is not sufficient. Also, the waiting period must be waived by all the consumers entitled to the waiting period.

Prohibited Provisions
High cost mortgages may not contain certain provisions, including balloon payments, negative amortization, advance payments, an increase in the interest rate after default, the rule of 78s in calculating prepayments, or a prepayment penalty except under certain conditions.

Prohibited acts and practices
In addition to restricting the terms, the new law and regulation prohibit creditors from certain acts and practices. Creditors may not extend credit to customers who cannot repay based on underwriting standards. This provision should be carefully considered in the context of your bank's CRA and fair lending programs.

The rule also prohibits making payments directly to a home improvement contractor unless the borrower is a joint recipient of the payment or the payment is made through an escrow agent. This restriction is designed to protect consumers from credit arrangements generated by unscrupulous contractors. Under this rule, the contractor will only be paid if the borrower agrees to the payment.

Finally, the note must contain a notice which preserves the consumer's claims and defenses. This has the effect of bringing the Federal Trade Commission's "Holder in Due Course" rule into this part of Truth in Lending. The clause is designed to prevent negotiation of the note in a way that would otherwise cut off the consumer's claims and defenses against the contractor or original creditor.

Use of Estimates
Because disclosures must be provided before consummation, it will sometimes be necessary to give estimated disclosures. The high cost mortgage rules bring in the same requirements as those contained in ?226.17. The disclosures must reflect the legal obligation, they must use the best information available to the bank at the time the disclosures are prepared, and they must also clearly identify the estimated information as an estimate.

Action Steps

Review your loan, products - particularly any balloon, loan products - to determine whether the finance charge triggers high cost loan disclosures.
Advise your bank management and lending staff of the existence of this rule. Provide them with information about the key terms which make loans "high cost mortgages." Use this opportunity to remind them to notify you whenever new loan products are developed so that you can assess the compliance consequences of the new product.
If you make high cost mortgages, get to work on your new disclosures! Compliance with this rule became mandatory October 1, 1995.