All mortgage originators should be familiar with how federal law defines “high-cost mortgages” and how such mortgages are regulated. This is especially important for originators of higher-risk, B- or C-paper mortgages or for brokers who work with private investors. Because these mortgages have a higher risk, they typically come with a higher rate and costs to consumers.
The Home Ownership and Equity Protection Act (HOEPA) of 1994 defines high-cost mortgages. These also are known as Section 32 mortgages because Section 32 of Regulation Z of the federal Truth in Lending Act implements the law. It covers certain mortgage transactions that involve the borrower’s primary residence. The law does not apply to mortgage transactions that involve investment properties, commercial real estate or real estate purchases.
HOEPA’s high-cost provisions apply to a mortgage when either the interest rate or the costs exceed a certain level or trigger point. The interest rate that the law refers to is the annual percentage rate (APR) shown on the truth-in-lending statement, not the interest rate shown on the promissory note.
With high-cost mortgages, this law requires certain additional disclosures be made in a timely manner. Moreover, when the mortgage qualifies as a Section 32 mortgage, the law restricts certain terms in the mortgage.
Here are the key indicators and issues involved with high-cost mortgages.
Rate trigger point
For a first mortgage, the interest-rate trigger point occurs when the loan’s APR exceeds 8 percent more than the rates on Treasury securities posted on the 15th of the month prior to the application and is of comparable maturity. When the 15th of the prior month occurs when the market is closed, then originators may use the next open market day. To find these Treasury rates and comparable maturities, you must use the federal H15 report, which can be found online at www.federalreserve.gov/releases/h15.
Here’s an example of how it works: Suppose you are funding a 10-year mortgage with an APR of 13.75 percent, and you take the application in June. To test if the mortgage is a Section 32 loan based on the interest rate, you look up the 10-year Treasury yield posted on May 15. Say you find the 10-year Treasury yield was 5 percent. You then add 5 percent (the Treasury yield of comparable maturity) to 8 percent (first-mortgage interest-rate-trigger test) to come up with 13 percent. The 13.75 percent APR on the mortgage therefore exceeds this 13-percent trigger point.
Consequently, this mortgage would be a Section 32 loan, and it must comply with Section 32 disclosure requirements, terms and restrictions.
Second trigger test
The other trigger-point test you must use to determine if a mortgage is a Section 32 mortgage has to do with certain fees (i.e., costs) that borrowers pay at or before closing. These costs typically are paid out of the loan proceeds.
The mortgage would be a Section 32 loan if certain fees and points, including the mortgage-broker fees, that borrowers pay at or before closing exceed $547 (2007 amount) or 8 percent of the total loan amount, whichever is larger. The Federal Reserve Board adjusts the dollar amount annually based on changes in the Consumer Price Index. The mortgage-broker fee and other fees are almost always higher than $547, so the 8-percent guide will be your typical cost-trigger test.
HOEPA refers to any fees that could be considered prepaid finance charges; this typically includes any fees borrowers pay to the mortgage originator, broker or lender.
For example, the following fees are commonly considered prepaid finance charges:
- The mortgage-broker fee;
- Application fee;
- Processing fee;
- Points to the lender;
- Points to the broker;
- Origination fee;
- Courier fee;
- Discount fee;
- Discount points; and
- The document-preparation fee.
Regardless of what the fee is called, if it goes directly to the lender or broker, Regulation Z likely considers it a prepaid finance charge.
Other charges also may be included in the fees that must be added to complete the cost-trigger test. These charges usually are not part of a private mortgage transaction, but they apply to large institutional lenders that sell credit life and disability insurance with the mortgage or that own part of the title company or appraisal company.
Because regulators can often change regulatory definitions, you should consult a mortgage attorney about which fees should be added for this calculation. The lender’s and broker’s software should keep up with these changes, but it would be wise for all mortgage originators to have a working knowledge of the regulators’ definition of prepaid finance charges. If you are not sure if a particular fee is a prepaid finance charge, err on the conservative side and consider it so. This is always prudent when trying to comply with laws and regulations.
You also must determine the total loan amount to complete this test. The total loan amount under HOEPA is not the total loan shown on the promissory note; rather, it is the “amount financed” shown on the truth-in-lending statement.
When the originator, broker or lender owns part of a third-party company involved in the transaction, then HOEPA’s total loan amount may be even less than the amount financed. Most originators and lenders, however, would use the amount shown in the amount-financed block of the truth-in-lending statement to complete the trigger-point test for costs.
An attorney also can best determine if using the figure of the amount financed on the truth-in-lending statement is appropriate for you.
Completing the cost-trigger test is relatively simple: You divide the total prepaid finance charges by the amount financed on the truth-in-lending statement. For example, if the total prepaid finance charges are $5,300, and the amount financed on the truth-in-lending statement is $65,000, then you divide $5,300 by $65,000. The result is 8.15 percent.
This exceeds the trigger point of 8 percent, thus making this mortgage subject to Section 32 regulations.
For second mortgages, the trigger tests are similar to the first-mortgage tests. The trigger test for costs is the same; there is a difference with the trigger test for the APR, however. With a second mortgage, if the APR exceeds 10 percent of the percent of the Treasury rate of corresponding maturity in the prior month’s H15 report, then it is a high-cost mortgage.
Why does it matter if a mortgage falls under Section 32? There are a number of required disclosures for these mortgages, which lenders must give to borrowers at least three business days before closing.
First, the lender must give borrowers a written notice that states that the loan does not have to be completed, even though they signed the application and received the preliminary truth-in-lending statement and other required disclosures.
The lender also must inform borrowers that there will be a mortgage lien against their home and that they could lose their home and all their equity in a foreclosure if they do not make payments. In addition, the lender must disclose the exact APR, which will be redisclosed at closing, and the exact regular payment, including any balloon payment (where state law permits). The disclosure must show the loan amount along with any credit insurances.
Borrowers have three business days to decide if they want to proceed to the closing. They also are given three additional business days after closing to change their minds (i.e., the rescission period).
There are several restrictions for Section 32 mortgages, as well. First, under this federal law, balloon payments cannot occur earlier than 60 months. State laws may be more restrictive with balloon payments.
In addition, there cannot be negative amortization with these mortgages. This occurs when the minimum payment does not cover the interest due each month, which results in interest backing up and increasing the balance due.
Further, the default interest rate cannot be greater than the initial rate on the promissory note. In addition, no more than two regular monthly periodic payments may be paid in advance from the loan proceeds at the closing.
With one exception, there cannot be prepayment penalties with Section 32 mortgages. Exceptions must meet three conditions:
- The lender has verified the borrowers’ gross income through third-party sources, and the borrowers’ debt ratio after the new loan will be 50 percent or less.
- The money used to prepay the mortgage does not come from and is not affiliated with the current lender. This would prohibit a prepayment penalty being charged if the current lender refinances the mortgage.
- The prepayment penalty does not exceed the first five years of the mortgage.
Due-on-demand clauses also are restricted. Such clauses can only be used if borrowers: commit fraud or material misrepresentation in connection with the mortgage; fail to make payments as agreed; or fail to maintain the security for the loan (i.e., the home or residence) or take any action that adversely affects the security.
With Section 32 mortgages, lenders also must consider the borrowers’ ability to repay the loan. The mortgage cannot be made solely on the real estate value.
The proceeds check from the loan to be used for home improvement must be made out to the borrowers, to the borrowers and an appropriate licensed contractor, or to an escrow agent with an agreement that a check be made out to the borrowers and an appropriate licensed contractor. This gives borrowers control over paying the contractor.
In addition, no lender may refinance a borrower into a Section 32 mortgage within the first 12 months of the original Section 32 mortgage, unless the refinance is demonstrated to be in the borrower’s best interest. This would also apply to anyone buying the mortgage after closing.
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Many states have their own high-cost-mortgage laws modeled after Section 32 of Regulation Z. In fact, some state laws actually are more restrictive than the federal law.
For instance, under Section 32, a mortgage cannot balloon sooner than five years; in Florida, a mortgage falling under its definition of a high-cost mortgage cannot have a balloon payment within its first 10 years.
Consequently, all mortgage-origination professionals should become familiar with these mortgages and their particular state’s high-cost-mortgage law. Your state may have a different name for it such as “the Fair Mortgage Lending Act,” the “Home Loan Protection Act” or the “Anti-Predatory Lending Act.” If your state has not passed such a bill yet, it’s likely that it is working on it.