I have a community bank that approves an applicant's real estate loan for 30 years, but changes the rate & payment every 3 years with balloon Notes until the debt is paid (there is no credit recheck or re-underwriting of the loan either). I noted under Reg Z that these arrangements may be handled as ARMs. The bank would like to try this to avoid all the early RESPA disclosures and HUD-1, getting a new application under ECOA, and re-reporting HMDA. It seems feasible to me when looking at the definitions of refinancings by regulation one-by-one. For it to work, I would recommend that the applicant receive the early ARM disclosure and booklet at application time, a Reg Z ARM notice prior to the interest rate change, and a new balloon Note & Reg Z disclosure at renewal (the bank charges a fee every three years at renewal, but the customer pays the fee out his pocket and there is no new proceeds to trigger a Right To Cancel), and a flood re-cert. I wondered if any of you would share your experince with this or if you have any recommendations on this procedure. Do you see any holes regulatory- or procedural- wise? If the renewal fee is financed by increasing the remaining balance, does the addtional proceeds negate the ARM process? As always, your advice would be appreciated.

If this bank is writing a 3 year loan, ammortized for 30 years that has a balloon payment at the 36th payment, then this is probably NOT an adjustable rate mortgage.

There are a couple of things to look at: 1) is the bank obligated to refinance the loan at the end of the 3 years? If not, this is not an ARM per Federal Law. 2) Is there any state laws issues that say this is an ARM.

The bank should not deliver CHARM booklets and ARM program disclosures. They should also NOT recieve any ARM change notices.

The bank can issue a new note every 3 years or simply write one note with 36 payments and then renew (not refinance) the note every 3 years. I know of several banks that do this. The renewal notice should reference the old note #, state the new interest rate and payment and state something like "all other terms and conditions remain the same."

Sounds like an ARM to me--at least for Reg Z purposes. If the bank "...approves an applicant's real estate loan for 30 years, but changes the rate & payment every 3 years with balloon Notes....", then the bank has obligated itself to the renewals.

David, I appreciate your comments. However, the situation is what is described in Reg Z,as Richard referenced, that states 'Variable-rate transactions include renewable balloon-payment instruments where the creditor is both unconditionally obligated to renew the balloon-payment loan at the consumer’s option (or is obligated to renew subject to conditions within the consumer’s control) and has the option of increasing the interest rate at the time of renewal.' My bank obilgates itself when approving the application. If this is an ARM, I'm hoping that the early RESPA disclosures, ECOA's written application requirment on refinances, and HMDA would not be applicable.

Also, you alluded to a process in which a document is used to replace an expired obligation and calling it a 'renewal' would eliminate the need for all of the above mentioned regulatory requirements. I can't find this treatment grounded in any regulation. Reg Z and other regs states that a refinancing occurs when an existing obligation is replaced by another obligation by the same borrower. I don't see how coining a document as a 'renewal' that replaces an existing obligation that is extinguished in 36 months changes the treatment of a refinancing as defined. I would appreciate your comments so as to help my bank.

Patrick T. Hubbs, CRCM, CBCO

As a follow-up, HMDA says that 'A refinancing involves the satisfaction of an existing obligation that is replaced by a new obligation undertaken by the same borrower. But do not report a refinancing if, under the loan agreement, you are unconditionally obligated to refinance the obligation, or you are obligated to renew or refinance the obligation subject to conditions within the borrower's control.' Under this definiton, I believe that I would not have to re-report these loans every 36 months if they are treated as ARMs.

Patrick T. Hubbs, CRCM, CBCO

I was not assuming that the bank "...approves an applicant's real estate loan for 30 years, but changes the rate & payment every 3 years with balloon Notes....". I was assuming the bank approved a loan for 3 years and was NOT obligated to refinance (or renew) the note. In my part of the country we see a lot of 3-5 year loans with an ammortization of 15-30 years.

Pat - Section 226.20(a) is very clear that a renewal (a specific term that means the original note is not satisifed and replaced but rather amended) does not require new disclosures. Much has been discussed in the BOL forums about renewals vs. refinancings. RESPA and HMDA also say the same thing. You said Also, you alluded to a process in which a document is used to replace an expired obligation and calling it a 'renewal' would eliminate the need for all of the above mentioned regulatory requirements. The key error to your statement is you said "a document is used to replace an expired obligation. A renewal does not replace the loan but rather extends the loan with certain modifications. Also read the commentary to 226.20 and 226.23(a)(1)#5 - where it discusses adding new money to an existing obligation without giving new disclosures (except a Right of Rescission).

Now, you may not agree ethically (many people don't) with what is allowed, but it is perfectly legal and authorized by regulation.

David,

Thank you for your clarification.

I was aware of the renewal exception; but in my case, the loan is in monthly principal & interest installments that balloon in three years. The renewal exception in 226.20 (a) applies to a single payment obligation. The commentary states the exception applies both to obligations with a single payment of principal and interest and to obligations with periodic payments of interest and a final payment of principal. As much as I would like it to, the renewal exception doesn’t appear to apply in my particular situation. Because of this, I was inclined to rely on 226.17(c)(1) that specifically states that renewable balloon payment instruments in which the creditor is unconditionally obligated to renew (subject to conditions under the consumer’s control) is a variable rate transaction. And as a variable rate transaction of more than one year secured the principle dwelling, the early program disclosure & booklet and the periodic rate change notices have to be furnished.

Do you think I’m on point in my assessment? As you can imagine, I’m pretty scared of signing off on a process that eliminates all the real estate disclosures unless it’s absolutely defendable in the regulations.

Also, can any other posters relate some hands-on experience or advice they have had with this issue?

Patrick T. Hubbs, CRCM, CBCO

Pat, What do you use to determine your new rate? Do you use prime or index rates or what ever the going rate is at balloon time? Our bank is almost 4 years old, when they first began just about all loans were balloon, I have now changed that to all ARM's due to the very reasons you are talking about. Also the time it takes to redo all docs. Let me know how you work your adjustments.

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Marsha Shelton

Marsha,

The bank wants to maintain control and discretion over the peridodic rates, and and not tie it to a particular index. This appears okay under Reg Z, as the commentary [19(b)(2)(ii)] on variable rate changes relates that 'if interest rate changes are at the creditor's discretion, this fact must be disclosed'. Since the bank has not maintained a history of it's rates, I will recommend that the early ARM disclosure reflect the alternative payment example (see model clause H-4) and not the historical example. This option became available in 1997. Though, my bank uses Bankers Systems forms and I'm not sure yet if the 'at the lender's discretion' language is avaiable as a default. I may have to create an ARM disclosure myself.

By the way, do you happen to have the regulatory cite that would exempt the RESPA disclosures every three years in this situation? I'm not entirely sold on eliminating the REPSA disclosures yet. I haven't found anything that nails it for me. I did note that #6 states 'Any conversion of a federally related mortgage loan to different terms that are consistent with provisions of the original mortgage instrument, as long as a new note is not required, even if the lender charges an additional fee for the conversion.' But in my case, and likely yours, a new Note is executed every three years.

I appreciate your input.

Patrick T. Hubbs, CRCM, CBCO

Pat - you said:
The renewal exception in 226.20 (a) applies to a single payment obligation. The commentary states the exception applies both to obligations with a single payment of principal and interest and to obligations with periodic payments of interest and a final payment of principal. As much as I would like it to, the renewal exception doesn’t appear to apply in my particular situation.

The rules provided in 226.20(a) apply to much more than single payment loans. Here is an excerpt from one of my manuals on this topic:
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[u]Refinancing vs. Renewals, Modifications, Extensions, etc.:[/u] [Section 226.20(a)]
1. A refinancing occurs when an existing obligation is satisfied and replaced by a new obligation undertaken by the same consumer. A refinancing is a new transaction requiring new disclosures to the consumer. The following shall not be treated as a refinancing:

a) A renewal of a single payment obligation with no change in the original terms.
b) A reduction in the APR with a corresponding change in the payment example.
c) An agreement involving a court proceeding.
d) A change in the payment schedule or a change in collateral requirements as a result of the consumer’s default or delinquency.
e) The renewal of optional insurance purchased by the consumer and added to an existing transaction.

2. A refinancing is a new transaction requiring a complete new set of disclosures. Whether a refinancing has occurred is determined by reference to whether the original obligation has been satisfied or extinguished and replaced by a new obligation, based on the parties’ contract and applicable law. The refinancing may involve the consolidation of several existing obligations, disbursement of new money to the consumer or on the consumer’s behalf, or the rescheduling of payments under an existing obligation. In any form, the new obligation must completely replace the prior one [Commentary to Section 226.20(a) #1].

· Changes in the terms of an existing obligation, such as the deferral of individual installments, will not constitute a refinancing unless accomplished by the cancellation of that obligation and the substitution of a new obligation.
· A substitution of agreements that meets the refinancing definition will require new disclosures, even if the substitution does not substantially alter the prior credit terms.

3. The addition of a security interest in a consumer’s principal dwelling to an existing obligation is rescindable even if the existing obligation is not satisfied and replaced by a new obligation, and even if the existing obligation was previously exempt (because it was credit over $25,000 not secured by real property or a consumer’s principal dwelling). The right of rescission applies only to the added security interest, however, and not to the original obligation. In those situations only the (right of rescission) notice need be delivered, not new material disclosures; the rescission period will begin to run from the delivery of the notice
[Commentary to Section 226.23(a)(1) #5].

4. Any time a bank makes, extends, renews or modifies a loan secured by improved real estate, a Standard Flood Hazard Determination Form must be completed.
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When the regulation discusses single payment loans [paragraph 1a) above] it means that if you gave me a 6 month single payment loan and at the end of 6 months, extended it again for 6 more months (with no other changes) you would not have to give me a new TIL disclosure, even if you replaced the loan with a new note. Why? Becuase the TIL disclosure would look just like the first one. The exemptions listed in a) through e) state that even if you prepared a new note, you would not have to give new disclosures. What is mentionned in the first part of 226.20(a) and in the commentary is that in all other cases, unless you replace a note, you don't have to give new disclosures.

You also said: I’m pretty scared of signing off on a process that eliminates all the real estate disclosures unless it’s absolutely defendable in the regulations.

I agree. Some lenders abuse this situation to get around RESPA. I saw a Federal Reserve examination report that indicated they thought the bank was using this exemption to "fraudently circumvent disclosure requirements." That is not what you want to have in a report. But these rules make sense sometimes too.

Maybe I'm missing something, Pat, but why not forget about doing balloon renewals and set these loans up as 3-year ARMs right from the start? Since the bank is obligated to renew every three years, I don't see any advantage to using balloon renewals instead of a regular ARM loan, unless the bank wants the renewal fee income.

THE OPINIONS EXPRESSED ARE MINE AND NOT THOSE OF MY EMPLOYER.

Lee,

That's a good point and it would solve a lot of issues. I had discussed this with the loan management. Unfortunately, there is some overall resistance to change from the familier. Also, there is a feeling that the term 'adjustable rate mortgage' will turn-off their customers.

David,

Thank you for the additional information. It seems to me that, except for the specific exceptions in 226.20(a), most of the refinancing vs. renewal debate hinges on if an existing obligation is actually satisfied by another obligation. And, that is likely depending on the precise drafting of both contracts and state law.

You also hit the nail on the head about my concerns. Even if all of our practices are on point with Truth In Lending, RESPA is a looming question in my mind, which is overall imprecise and subject to widely differing interpretations. Obviously, the intent of the bank is primarily to eliminate the RESPA disclosures (as well as avoid additional HMDA reporting). However, I'm also concerned that the regulators would view this attempt as an illegal circumvention. The risk level is simply to high for my blood.

My gut tells me to recommend that the bank makes a choice: either Lee's method or do the disclosures and report it under HMDA. (This kine of reminds me of a saying by the philosopher Mick Jagger, 'You can't always get what you want'.)

Thank you all for your input.

Patrick T. Hubbs, CRCM, CBCO