Complying with HOEPA
On October 1, 2002, the new rules and lowered triggers for HOEPA loans took effect. It is a good idea to take a lending compliance tune-up. First, take a hard look at the new rules and a second look at your lending practices.
The New Triggers
First, there are changes to the triggers for high cost loans. For loans secured by a first lien on the consumer's dwelling, the trigger has been lowered from 10 percentage points to 8 percentage points of the yield on Treasury securities having comparable periods of maturity. The trigger remains at 10 percentage points for loans secured by subordinate liens.
To assess the trigger, look to Treasury securities having a comparable maturity to the loan. The Treasury security index should be selected as of the fifteenth day of the month preceding the month in which the application is received by the creditor.
This provides one more important reason to document when applications are received.
Note that the selection of the Treasury index for purposes of calculating HOEPA loans is completely unrelated to the index selection and use for adjustable rate mortgages. Setting the rate for an ARM and determining HOEPA coverage are two separate and distinct exercises.
The other HOEPA trigger is based on total finance charges and fees as a percentage of the loan amount. There are tricks here, also. Just as the interest rate calculation is unrelated to index selection for the ARM, the finances charges are different from - and greater than - the finance charges that you calculate and disclose for the loan.
There are special calculation procedures for the HOEPA trigger finance charge. First, count and include all fees that are usually finance charges. Second, you may have to include charges that are exempt from the finance charge for normal TIL calculation purposes. Fees that are exempted from the finance charge in §226.4(c)(7) must be included if they are not reasonable (in which case you have probably violated RESPA), if they include compensation of any kind to the institutions, and if they are paid to an affiliate.
Next (and this is new), the amount of any credit life, accident, or loss of income insurance must be included in the finance charge. If the insurance is required, it is already a part of the finance charge for disclosure purposes. However, HOEPA now includes voluntary credit insurance for purposes of calculations. The fact that you have properly disclosed it and the customer has voluntarily chosen to purchase the insurance (which keeps it out of the finance charge for purposes of regular TIL disclosures) does not allow you to exclude it from the HOEPA calculations. It is in because of what it is.
Because voluntary credit insurance is included, a loan may become a HOEPA loan at closing when the borrower decides to make the purchase. If this happens, you must prepare HOEPA disclosures and delay the closing for three days while you and the borrowers wait out the mandatory HOEPA thinking time.
The other changes to HOEPA involve protections of consumers from a variety of creditor practices that are considered predatory. These prohibitions illustrate the regulatory concerns about unfair and deceptive practices. The list of prohibited practices isn't anything amazingly new or different, but it does illustrate the concerns that regulators have raised about both predatory lending and unfair or deceptive trade practices.
Financial institutions have not, for the most part, made use of the prohibited practices. That has been the territory of other lenders. As a result, most of the practices that are now prohibited will not mean changes for financial institutions. But you should check your contracts anyway.
The prohibited practice most likely to affect financial institutions is the limitation on balloon payments. Many smaller banks have used balloon loans as an alternative to adjustable rate mortgages. However, balloon payments are prohibited on HOEPA loans having terms of less than 5 years. This means that the popular three-year balloons should be priced very carefully to be sure that HOEPA coverage isn't triggered.
HOEPA covered loans must also have regular payments to pay down the principle or at least pay interest. Concerns have been expressed about a lender practice of making a loan with a single payment at maturity - which the borrower cannot pay and must therefore refinance or face foreclosure.
Loans having any kind of interest or payment adjustment that could result in negative amortization won't fly. The payment schedule must at a minimum pay off interest. Ideally, the payments will also reduce principal. Adding costs to the principal, resulting in negative amortization, is strictly prohibited for HOEPA loans. This means that any interest rate changes and payment schedule caps must be coordinated to avoid negative amortization.
Another consumer protection provision requires lenders to include a statement in the disclosure that the consumer is not required to complete the credit transaction. This disclosure is intended to protect consumers from pressure tactics that imply the consumer is already locked in to the agreement or that canceling will be prohibitively complex or expensive.
Several of the consumer protections set limits on the pricing of the loan. Loans subject to HOEPA must not include more than two advance payments from the loan proceeds. The borrower should get the maximum use of the funds and have a legitimate opportunity to use the loan proceeds.
Acceleration clauses are part of the predatory practices that HOEPA controls. The regulation prohibits increasing interest rates if the customer is in default.
HOEPA also places limitations on prepayment penalties. The goal is to avoid unfair practices that lock consumers into loans that may not be or are no longer in the consumer's best interest. Prepayment penalties are generally prohibited unless limited to the first five years of the loan. Prepayment penalties are also prohibited if the consumer's total monthly debts including the HOEPA loan exceed 50% of the consumer's gross monthly income verified by the creditor.
Prepayment penalties include practices such as calculating refunds of unearned interest using methods less favorable than the actuarial method or taking funds to pay the penalty from the loan proceeds in a refinancing of the debt. This particular prohibition, using funds from a refinancing to pay a prepayment penalty, also applies to affiliates of the creditor. This prohibition is targeted towards creditors that roll borrowers next door to affiliates with the result that the holding company of both creditors reaps the profit while driving the consumer deeper into debt.
Closely related to the prohibition of these types of costs paid by borrowers is the prohibition against loan flipping. Refinancing a HOEPA loan within a one year period is strictly prohibited unless it is clearly in the borrower's interest. Demonstrating the borrower's benefit could include situations such as a significant reduction in the interest rate, removal of a variable rate feature, or re-amortizing the loan to lower monthly payments without charging significant fees.
The loan flipping practices targeted by this rule include the practice followed by The Associates in contacting borrowers 90 days after closing to propose refinancing or new loan products. This limitation applies to affiliates and assignees as well as the original creditor. As a practical matter, lenders should determine that an applicant seeking to refinance a loan has held the loan for at least one year.
Demand clauses, including any provision that would enable the creditor to call the loan before maturity, are strictly prohibited. Only certain behavior of the consumer would permit the lender to call the loan. Consumer behavior such as fraud, material misrepresentation, default, or damage to the security property would justify the lender in calling the loan.
Other protections involve contractual provisions that put third parties on notice. The HOEPA rule effectively implements the FTC's "Holder in Due Course" by preserving the consumer's claims and defenses if the loan is sold. The notice alerts assignees that the loan is subject to the consumer's claims and defenses against the original creditor. The notice also alerts the assignee to the fact that the loan is subject to HOEPA rules.
Finally, the rule includes protections for consumers obtaining home improvement loans by requiring that the proceeds be paid to contractors only in ways that are subject to the borrower's control and approval. Loan checks for home improvement contracts must either be jointly payable to the consumer and the contractor, or they must be payable through a third party escrow agreement.
The new rule makes it illegal to make a HOEPA loan to a customer without verifying that the customer can repay the loan. HOEPA rules require lenders to compile written verifications of income and to create a written record of calculating ratios such as debt to income or documenting a cash flow analysis. The best place to do this is on the loan officer's work sheet.
Documentation is not a new issue. We have fully discussed documentation in the context of fair lending. The DOJ attorney's have expressed their opinion that if the loan officer didn't document something, they didn't do it. Failure to document something thus limits the institution's ability and credibility to bring it up later to explain a decision or action.
For fair lending purposes, documentation is needed to establish that the creditor gave fair and consistent treatment to all customers. Missing documentation in a loan file implies that the lender skipped that step for that customer.
In predatory lending, the considerations are somewhat different, but closely related to the fair lending concerns. For purposes of protecting consumers from predatory lenders, HOEPA rules require lenders to document the fact that the consumer has the financial ability to repay the loan. A loan made to a consumer who cannot repay the loan is not responsible lending; it will be seen as a method of reaching the consumer's property - and destroying the consumer's economic well-being in the process.
Copyright © 2002 Compliance Action. Originally appeared in Compliance Action, Vol. 7, No. 12, 10/02
- Alert lenders to the HOEPA tests so that they are aware of any lending that could be subject to HOEPA disclosures.
- Review a sample of dwelling-secured loans (not purchase money) and test them for HOEPA coverage.
- Review loan agreements for any provisions that are prohibited in HOEPA loans. Discuss the need for these clauses with your lenders. Eliminate the clauses if they are not needed.
- If you find loans that trigger HOEPA coverage, sit down with your real estate lenders and develop compliance procedures.
- Your lenders can also decide to stop making loans priced to trigger HOEPA coverage.
- Review the lending procedures for home improvement loans and refinancings. Include steps to flag transactions that are subject to HOEPA provisions.
- If you don't have one already, establish a minimum standard for loan documentation.