Refinancing and Construction Loan Disclosures

Question: We are making a complicated loan to a customer. The customer is making significant improvements to his house and also wants to refinance the existing mortgage. The loan would be $95,000 for refinancing and $100,000 for the improvement project. The borrower wants to pay interest only for a term of one year. At that point - when construction is expected to be complete, the borrower will take out permanent financing. We have struggled with what disclosures to provide. Could you help?

Answer: First, any loan secured by a dwelling or improved real estate is subject to most of the consumer protection laws, including ECOA, FCRA, and Flood. But the primary questions for this loan transaction lie in Truth in Lending and RESPA. Let's take RESPA first, because there is an easy answer. If the loan is for a term of less than 2 years, it is exempted. Since it appears that this loan will be only for one year, the GFE and HUD-1 disclosures are not required. You may always give them voluntarily.

The more difficult situation lies with Truth in Lending. There is no short-term exemption for Truth in Lending, so you must provide accurate disclosures. You didn't specify whether this will be one loan or two. We recommend making this two loans, one for the refinance which will be fully drawn as soon as the rescission period expires, and one for the construction portion of the loan. This will be the only viable way to generate an APR.

The challenge with construction loans is that you don't know how much will be drawn at any given time during the loan. To deal with this problem, Regulation Z offers Appendix D, which allows you to make certain assumptions about the loan balance and loan draws. However, you may only use Appendix D if the loan fits the terms laid out in the Appendix - and your loan does not. The problem with your loan is that, if made as a single transaction, the customer would have an immediate draw of almost half the loan balance to pay off the existing mortgage. That kicks it right out of Appendix D. This leaves you on your own for calculating an APR and we don't recommend trying that. Instead, solve the problem by dividing the loan into two separate loans. One is a straight-forward refinance with a term of one year and interest payments only. The second one is a construction loan that does fit the requirements of Appendix D.

Now for timing. The early disclosure requirements of Regulation Z are triggered by several factors, one of which is being subject to RESPA. Since the loan is exempt from RESPA because of the short term, you do not have to provide early disclosures. The only required disclosures would be the TILs for each loan at or just before closing. And, don't forget the rescission notices! This loan is definitely subject to rescission.

Copyright © 2005 Compliance Action. Originally appeared in Compliance Action, Vol. 10, No. 5, 4/05