Truth in Lending Does Not Improve With Age

In the entire universe of bank regulatory compliance, there is nothing yet on the books that equals Truth in Lending - not even allowing for tolerances. Although Truth in Lending is close to 30 years old, it still tops the list of compliance violations.

In FIL-20-98, issued February 25, 1998, the FDIC discussed two Regulation Z compliance and restitution problems: credit life, and construction loan APR calculations. Although issued only by the FDIC, the problems treated in the FIL are found by all the agencies - and found too often.

Problem #1: Credit Life Insurance
FIL-20-98 identifies several errors in treating credit life disclosures. First, lenders often fail to correctly identify programs that are treated as credit life insurance by Regulation Z. For example, some creditors assume that loss-of-income or accident income is not credit life insurance subject to the disclosure requirement. The regulation does not stop with the name of a product; the regulation looks closely at the nature and substance of the transaction. The key element here is that if the insurance (or insurance substitute) is written in connection with the credit transaction and protects the creditor, either directly or indirectly, it is credit life insurance for purposes of Regulation Z.

The second common problem with credit life insurance are the required steps to exclude credit life insurance from the finance charge. There are three required steps and all three must be properly executed in order to exclude the premium from the finance charge.

The insurance must be optional and the fact that it is optional must be disclosed in writing to the consumer.

The disclosure must show the premium for the initial term of insurance. The disclosure should show the cost of insurance for the initial premium and should also specify the term of insurance if it is less than the term of the credit transaction.

The consumer signs or initials the disclosure indicating that he/she/they wish to purchase the insurance.

All three of these steps are essential in order to exclude the fee from the finance charge. This particular disclosure can be provided with other Truth in Lending disclosures or can be on a separate paper. Location is not the issue. Taking the three steps is essential.

Examiners will determine whether all three steps have been met, paying particular attention to the clarity of disclosures to assess whether the consumer understood them. The consumer's signature indicating the request for insurance is essential. When examiners see a pattern of frequent requests for credit life insurance, they will question whether the insurance is really voluntary. A high sales record may indicate that customers are being advised that the insurance is not really voluntary.

Problem #2: Construction Loans
The other Truth in Lending problem raised in FIL-20-98 is construction loan disclosures. Appendix D provides guidance, but only under two conditions. First, the appendix formulas must be used correctly. Second, the formulas may only be used for certain specific situations. If the construction loan fact situation doesn't match the assumptions made in Appendix D the formulas should not be used.

In calculating the APR, Appendix D assumes that half of the loan amount will be outstanding half of the time. This is a reasonable assumption for a multiple advance construction loan because advances made at three, four, or five points during the construction phase will average out to approximately this amount. However, if the loan is structured for a different draw pattern, the Appendix D formulas should not be used. Instead, you should use a formula based on the facts known at the time and the legal obligation. For example, if the loan contract called for 50% of the loan amount to be drawn at closing and three other equal installments to be drawn during the five month loan, the Appendix D formula would clearly not be accurate. In this case, the lender would have to develop a situation-specific formula. The easiest approach to construction loans is to offer loans that meet the assumptions made in Appendix D. Keep the product simple and match it to the Regulation. Whatever the bank's construction loan products, there should be regular reviews of lending and disclosure procedures as well as APR verifications.

ACTION STEPS

Review files to evaluate disclosure practices for credit life insurance or equivalent coverage. Make sure the three points (insurance is voluntary, premium specifically stated, customer's signature or initials) are properly dealt with.
Talk about disclosure issues related to credit life insurance with your retail and marketing staff.
Be sure they understand disclosure requirements before they develop a new product offering.
Review construction loan contracts and notes. Determine whether the contract provisions are consistent with the assumptions in Appendix D.
Review construction loan disclosures. Remember to check the contract provisions when you review the disclosures!