We offer consumers two choices at closing... they can be billed construction interest monthly based on the amount advanced or we can estimate the amount of construction interest for the term up front and pay their interest owed monthly based on the amount drawn. Is construction interest in option #2 a prepaid finance charge?

You have to calculate the interest on a construction loan based on Appendix D in Reg Z unless you know the amount and timing of the draws. How they actually pay the loan or what the actual interest charges end up being has no bearing on the calculation for APR purposes. I'm not sure I understand the difference between your two scenarios?

Wouldn't #2 be establishing an interest reserve and therefore have to follow the applicable disclosure requirement in # 5 to Appendix D?

#5?

Sorry Randy, it's # 5 in the OSC to Appendix D.

5. Interest reserves. In a multiple-advance construction loan, a creditor may establish an "interest reserve" to ensure that interest is paid as it accrues by designating a portion of the loan to be used for paying the interest that accrues on the loan. An interest reserve is not treated as a prepaid finance charge, whether the interest reserve is the same as or different from the estimated interest figure calculated under appendix D.

• If a creditor permits a consumer to make interest payments as they become due, the interest reserve should be disregarded in the disclosures and calculations under appendix D.

• If a creditor requires the establishment of an interest reserve and automatically deducts interest payments from the reserve amount rather than allow the consumer to make interest payments as they become due, the fact that interest will accrue on those interest payments as well as the other loan proceeds must be reflected in the calculations and disclosures. To reflect the effects of such compounding, a creditor should first calculate interest on the commitment amount (exclusive of the interest reserve) and then add the figure obtained by assuming that one-half of that interest is outstanding at the contract interest rate for the entire construction period. For example, using the example shown under paragraph A, part I of appendix D, the estimated interest would be $1,117.68 ($1093.75 plus an additional $23.93 calculated by assuming half of $1093.75 is outstanding at the contract interest rate for the entire construction period), and the estimated annual percentage rate would be 21.18%.

Yes - you are correct. I guess I just couldn't tell if they were truly talking about an interest reserve or not. Good point.

Thank you both, in the second scenario the consumer financed an additional amount to cover estimated construction interest which they will use to pay monthly interest on their loan ( not an interest reserve as lender did not require). So, do I understand point two under your #5 .. if the consumer directs when the interest is to be paid.. then whether they write a check themselves or authorize it to be paid from the loan, neith would be considered a prepaid F/C ?

We ran into this back in the early 1990s, and placed a one liner into the construction loan agreement that the borrower had the right to pay their own interest. This satisfied OTS at that time, and avoided the interest on interest question raised by Reg Z. Having the right to write the check was all it took - we still collected the interest reserve.

Chocaholic, before following MoMan's advice be sure your regulator is OK with it. OTS may have been satisfied, but your regulator may not be.

As for as "requiring" the reserve account I would not completely rely on you not requiring the reserve. The additional money they borrow to pay the interest with, do they have full control over that money, or do you indeed require them to place the money in a "reserve" account?

Hi Dan,
If the consumer wanted to pay interest by check one month they could, rather than advancing the interest from the loan... so I would say they do have control over the funds.I guess they have the same amount of control over those dollars as they have over construction draws... they can request them in a month or not. anyway, I will check with regulator as we are FDIC. Thank you again for your help!