ACTION AUDIT Regulation Z: Checking APRs

ACTION AUDIT
Regulation Z: Checking APRs

You cannot do a compliance audit of loans without checking the finance charge and the annual percentage rate calculations and disclosures. It is a basic part of any loan compliance audit. So the question is not whether but how.

Unfortunately, it is all too easy to review Truth in Lending disclosures without finding critical errors. That's because of the old but very true adage: garbage in, garbage out.

In checking TIL compliance, there are often key steps that are skipped. And by skipping these steps, the TIL review can miss the fundamental mistakes that caused the disclosure to be wrong. And sometimes, by missing the basic step that was in error, the audit merely confirms the mistake, believing it to be accurate.

This is why a TIL audit must start with - or go back to - the basics. The first basic is always the loan agreement. Why? Because of our favorite section of Regulation Z: ?226.17(c)(1). No TIL review is complete without it.

What ?226.17(c)(1) says is that the disclosures must reflect the terms of the legal agreement. A key test of the accuracy of disclosures is whether they reflect the legal agreement - or stray off into another pasture.

The closely related principle is that you cannot charge it if you didn't disclose it. So even if a loan contract provides for certain fees or interest calculations, you cannot exercise them if they conflict with the TIL disclosure that you gave to the customer when you closed the loan.

Usually ?226.17(c)(1) gets the most attention when we are trying to figure out whether a transaction is a refinance or a modification. We look to the underlying legal agreement and whether it is changed to make this determination. In this context, it is often a positive and helpful provision.

But ?226.17(c)(1) has a dark side and nowhere is it more evident than in the recently popular "premium rate adjustable rate mortgage." A premium rate ARM is a variable rate loan for which the first time period - anywhere from one to five years - is based on a premium rate which is actually higher than the index plus margin. After the premium period, the loan reverts to traditional variable rate adjustments.

Here's the catch: many of these premium rate ARMs have floors - a rate below which the loan simply won't go. Let's say that the loan originates at a premium rate of 5.75%. Then assume that the index plus margin would be 4.5%. But the loan has a floor of 5%. In other words, the loan rate will never drop as low as the current index plus margin.

Now for the mistake. Many of the TIL disclosures prepared on these loans ignore the floor of 5% and instead calculate the interest, finance charge and APR using the index-plus-margin rate of 4.5%. The disclosure shows the first payment stream of one year at 5.75% and the remaining 29 years at 4.5%. The result is a seriously under disclosed finance charge and APR because according to the note (enter ?226.17(c)(1)) that 4.5% rate is never going to happen.

When a compliance auditor simply checks the numbers on the TIL disclosures, the auditor won't find the mistake. To make sure this doesn't happen, the auditor should start with some additional steps.

Audit mortgage loans by each product type. Audit premium rate-ARMs separately from more standard instruments.
Review the note before you do anything else. Determine the key terms of the note that will affect the TIL calculations. This includes identifying any variable rate features, the timing and duration of those features, and any rate caps and floors. (Note: if the loan is dwelling-secured, it must have a rate cap.)
Run a payment stream for each rate cycle of the loan. Remember to use all of the variable rate assumptions - rates will change based on the loan agreement using the rates we know about at closing.
Amortize each payment stream for the appropriate time period and then calculate the next payment stream with the new amortization period.
Plug your payment numbers and rates into your APR checker. Do not use the same tool that was used to generate the disclosures in the first place.
Now compare the results. If necessary, calculate the restitution.
Determine how any errors occurred and recommend solutions to prevent such errors in the future.