Private money lenders predominately originate what are commonly referred to as business-purpose loans, usually secured by the value of a parcel of real estate. There’s another type of loan out there. It’s the consumer-purpose loan.
How the borrower uses the money from a loan matters greatly in the wake of compliance legislation passed in recent years. Originators who work with private money lenders need to understand this — particularly the difference between a business and consumer loan — or they risk causing the lender a great deal of heartache.
The difference between business- and consumer- purpose loans boils down to whether the loan is subject to the disclosure and other requirements of, among other statutes, the federal Truth-In-Lending Act (TILA). A consumer-purpose loan is subject to that consumer-disclosure law while a business-purpose loan is not.
While it may appear at face value that a business-purpose loan should be easily distinguishable from a consumer-purpose loan, in practice it’s not. There is a certain gray area — or twilight zone — which intersects the two types of loans.
Mortgage originators who work with private lenders should exercise the proverbial “ounce of prevention” at the outset to avoid having to expend a “pound of cure” on the back end of a loan deal. The goal is to ensure a borrower does not later claim that a business-purpose loan intended for a fix-and-flip investment property, for example, was instead a consumer-purpose loan that is subject to TILA.
Understanding the loan
In a nutshell, TILA is a consumer-protection statute that provides certain protections and remedies for a “natural person” against their lender. An originator who correctly determines at the outset that a proposed loan will ultimately be for a business purpose, rather than a consumer purpose, will prevent the borrower from later wrongly invoking TILA as both a sword and a shield against the lender.
The preventive benefits associated with making the correct determination at the outset of a loan transaction can best be described relative to whether the loan is a purchase mortgage or a refinance loan. If a private money lender originates a purchase mortgage, and it is later determined that the private money lender inaccurately designated that loan as a business-purpose loan, that lender may potentially be subject to a lawsuit by the borrower seeking actual damages, statutory damages and attorneys’ fees.
The same goes for a private money lender that originates a refinance mortgage, and it is later determined that the private money lender inaccurately described the loan as a business-purpose loan. In addition, in the refinance context, the borrower also has the unique remedy of rescission, effectively voiding the contract.
In this circumstance, the borrower has three years from consummation of the refi loan in which to exercise the right of rescission as to the inaccurately designated loan. A proper rescission requires the lender to reconvey its deed of trust, while the borrower is only required to tender to the lender the original principal amount of the loan, minus a credit for, among other things, the principal and interest payments previously made.
There are defenses to borrower claims under TILA and ways in which a lender’s damages can be mitigated. This, however, would fall under the “pound of cure” to be avoided with an “ounce” of prevention.
Type of borrower
Asking the right questions upfront will eliminate time wasted working on a loan that may have a consumer purpose. The first question one should ask is whether the credit being extended is to a natural or non-natural person. What is the difference?
A natural person is a human being (and some trusts). Loans to natural persons require the private money lender to properly determine at the outset whether a loan is a business-purpose loan or a consumer-purpose loan.
In contrast, entities such as corporations, partnerships, associations, churches, unions and fraternal organizations are considered non-natural borrowers that are exempt from TILA. Credit extended to entities such as these fall within the organizational exemption under TILA, and its implementing Regulation Z, and will not qualify as a consumer loan regardless of purpose.
While loans to natural persons require the private money lender to determine at the outset whether the proposed loan has a business or consumer purpose, a correct designation as a business-purpose financing allows the private money lender to originate the loan to a natural person without having to comply with the TILA. Moreover, even loans to a natural person that are secured by owner-occupied residential properties may qualify as business-purpose loans.
Some examples are provided by the Consumer Financial Protection Bureau (CFPB). Those include a loan to expand a business, even if it is secured by the borrower’s residence or personal property. Another is a loan to improve a principal residence by putting in a business office. Another example of business-purpose financing is a loan to acquire a rental property that is or will be owner-occupied within the coming year, if the property contains more than two housing units.
Details of the loan
Several factors must be considered when evaluating whether to extend credit for the purchase of owner-occupied properties for a business purpose. The first is what is the borrower’s statement describing the purpose of the proposed loan.
A statement from a proposed borrower that the proceeds of the loan will be used for a child’s school tuition, a medical expense or to go on a family vacation, indicates a consumer purpose. A mixed-purpose loan (part business, part consumer), may still result in a lender properly designating a loan as having a business purpose.
If a borrower is a licensed contractor who is going to use some of the proceeds of a loan to buy a truck to use for work and for personal purposes, for example, this could still qualify as a business-purpose loan. An originator working with a lender, however, must look deeper into the proposed loan before making the business-purpose determination. This would include determining, among other things, if the proposed borrower has any other vehicles that are used for personal purposes.
Originators also should determine if there’s correlation between the borrower’s occupation and the use of the loan proceeds. If a dentist, for example, proposes to use the loan proceeds to expand a dental practice or to modernize equipment, such as to purchase chairs and X-ray machines, this would have a greater likelihood of being for a business purpose.
Whether the borrower will personally manage the assets purchased with the loan proceeds is another factor to consider. To qualify as a business purpose, a borrower who will use the loan proceeds to buy an asset, enterprise, or to make an investment, must have a high degree of personal involvement in the asset’s management. If a borrower plans to use loan proceeds to purchase stock in a real estate holding company where the borrower doesn’t work, for example, that likely would be deemed a personal investment and a consumer-purpose loan, not a business-purpose loan.
In addition, the larger the size of the transaction, the more likely it is that the loan being used to fund it will be deemed to have a business purpose. The CFPB tends to take the view that individuals are less likely to need large loans for consumer purposes.
Finally, the amount of income derived from the property acquired by the loan proceeds also is a factor in determining whether it has a consumer or business purpose. The less income derived from the acquired property or asset, the more likely the loan will be deemed to have a consumer purpose. The CFPB is usually inclined to presume that the acquisition of an asset that is income-producing is more likely than not to be for a business purpose.
To the extent that there is one type of loan for which the CFPB does not see a “twilight zone” gray area between a business or consumer purpose, it is a loan secured by a nonowner-occupied rental property. Credit extended to acquire, improve or maintain a rental property (regardless of the number of housing units) that is not owner-occupied is deemed to be for business purposes.
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Business-purpose loans are the lifeblood of the private money lending industry. To keep that lifeblood pumping, private money lenders, and the originators they work with, must exercise an ounce of prevention on the front end of a loan deal to ensure that a business-purpose designation is appropriate. This due diligence will go a long way in preventing the private money lender from unwittingly making a consumer-purpose loan and potentially suffering a big hit to the bottom line later on as a consequence of that mistake.