Reg Z: Mortgage Lending: Working Through Rescission

Rescission is a tough topic. The stakes are high whether measured by dollars or customer relations. It is something that simply should be right - every time. The difficulty is that the rescission rules are confusing and about as easy to follow as a maze. In Vol. 6, Issue #5, we ran a question and answer on customer rescission rights for home equity lines of credit used in a home purchase transaction. That Q&A has generated more questions, to say nothing of lots of discussion in several threads on www.BankersOnline.com. So it seems useful to lay out some basic rules and precepts about rescission.

Whether customers have the right to rescind is driven by several factors. These include the status of the borrower, the nature of ownership or title to the property, and the relationship of the property to the loan. Each of these issues must be carefully thought through in order to make an accurate determination about rights to rescind the loan.

Question 1: Is the borrower a consumer?
For Regulation Z to apply, the borrower must be a consumer and be borrowing for consumer purposes. Regulation Z does not protect business purpose loans. Presumably, business borrowers are more experienced in managing finances and do not need Regulation Z's protections.

If the borrower is not a consumer, the loan is not subject to Regulation Z. For example, a business borrower, using the business owner's home as security, is a business purpose loan, not a consumer loan. That doesn't change simply because the business has offered personal property as security. Because the loan is not subject to Regulation Z, no right to rescind arises.

There is a possible exception to this supposedly clear concept. Confusion reigns when the "borrower" is a trust and the beneficiaries of the trust live in the house that will be securing the loan. If the trust's beneficiaries were the direct borrowers, they would have the right to rescind. However, because the borrower is a trust, not a consumer, the simple conclusion is that the trust may not rescind. However, there is a growing group of nervous compliance experts (including this editor) who wouldn't want to have to defend that decision in court. We are concerned that a judge would look through the trust, take into account the purpose of rescission which is to protect individual's homes from foreclosure, and rule that the consumers living in the home, as beneficiaries of the trust were also borrowers for purposes of the Regulation. Because of this concern, it is safer (but not clearly a requirement) to give the trust beneficiaries the right to rescind.

Question 2: Is the loan to be secured (in whole or in part) by the consumer's principle dwelling?
If the answer is yes, keep going. If the answer is no, the lender can disregard rescission. When the loan is secured by the home in which the consumer lives, the rescission rules click into place. The rescission rule is designed to give the consumer an opportunity to really think hard about the credit and the risk of putting up the home as security.

This protection of home ownership is high on the emotions list. Violations of rescission and the loss of a home tend to inspire a high level of sympathy for the consumer. Any bank violating the consumer's right to rescind - and the right to protect their home - is not in a good position to defend itself. The consumer is going to win this one hands down.

Question 3a: Is the loan being used to purchase the consumer's home?
Regulation Z's right to rescind does not apply to purchase money loans. The theory is that buying a home is a different kind of decision and transaction than using one's home as collateral for another purpose (such as aluminum siding.) So if the answer to this question is "yes," the transaction is probably (and we stress probably) not rescindable. However there are still more questions to ask.

Question 3b: Is any part of the loan secured by the customer's current home rather than or in addition to the home the customer is purchasing?
Even if the transaction involves a purchase, there can be times when the loan is subject to rescission. The most typical example of this is a bridge loan. The bridge loan is designed to facilitate the purchase by providing interim funds. Using the bridge loan, the borrower draws on the equity of the current dwelling to cover the financing of the new home until the sale of the old (current) home is finalized. The loan bridges the gap between the two home sales. When this situation arises, the bridge loan secured by the current/old home is rescindable. The purchase money loan is not rescindable. If both loans are made at the same time, one will be subject to rescission, the other will not.

Question 3c: Is the customer using a home equity loan to serve as a bridge loan?
Home equity lines of credit (HELOCs) are increasingly popular tools in the sale and purchase of homes. Because a HELOC is an open end line of credit secured by a dwelling, there are special rules that apply. Open-end credit can take a variety of forms. The most familiar version is a traditional HELOC which operates much like a credit card in that the line of credit is drawn down, paid up, and drawn down again. As Regulation Z defines open-end credit, the parties contemplate repeated transactions. This type of program typically has a pre-authorized credit limit up to which the customer may draw - over and over as long as it is also paid down. Other HELOCs can be more complex, involving requests for draws by the consumer. These loans may look much like a construction loan except that they have an open-end feature involving repayment and additional draws.

Regulation Z contains a confusing rule in ?226.15(a)(1). First, it appears to state that every advance or draw under a HELOC is subject to rescission. It specifically states that "each credit extension made under the plan" is subject to rescission. ?226.15(a)(1)(i).

But Regulation Z is nothing if not complicated. In subparagraph ?226.15(a)(1)(ii) it further states that the consumer does not have the right to rescind if the credit extension is made "in accordance with a previously established credit limit for the plan." Thus, a routine draw on a standard HELOC does not trigger the right to rescind. However, a draw that involves an increase in the credit limit or that must be approved by the lender would be rescindable.

So the question is, what do we do with a HELOC that is being used as part of a home purchase transaction? If the HELOC is being used like a true bridge loan, it secures the borrower's current home - the home that is up for sale. It is also the roof currently over the borrower's head and, like the traditional bridge loan, subject to rescission.

However, a HELOC can also function as a bridge loan but actually be secured by the home being purchased rather than the home being sold. This is a purchase money transaction and rescission would not apply to the HELOC. Because it is a purchase money loan, the borrower can write a check on the HELOC immediately and use this money to cover the gap until the sale of the first home is complete. The transaction covers the bridge loan problem, but has the advantage for the customer of being a HELOC that is in place at the time of purchase. Once that first draw is repaid, the line is replenished and the consumer can again draw on the line. There is one remaining problem. If the full line amount was used to make the purchase, the entire HELOC is exempt from rescission, but if only a part of the line was used for the purchase, the consumer may still have the right to rescind the rest of the line amount.

Copyright © 2001 Compliance Action. Originally appeared in Compliance Action, Vol. 6, No. 8, 8/01