Thursday, December 8, 2022

December 2006 Legal Briefs

Defense Authorization Act – Restrictions on Loans to Service Members and Their Dependents

  1. Background
  2. What Transactions are Covered?
  3. “Interest” Limited to 36%
  4. All Fees are “Interest”
  5. New Definition of “APR”
  6. No Lender Access to Bank Account
  7. No Renewal of Debt
  8. No Mandatory Arbitration
  9. Non-complying Contracts Void
  10. Criminal Provision
  11. What Persons are Covered?

Defense Authorization Act – Restrictions on Loans to Service Members and Their Dependents

As part of the 2007 Defense Authorization Act, Congress enacted provisions restricting the terms of consumer credit provided to service members and their dependents.  These provisions take effect October 1, 2007.

The new provisions were adopted hurriedly, as an amendment to a larger bill, with little review or input. Unless the provisions can be amended by legislation, or perhaps narrowed by regulations, banks may experience some serious compliance problems, as explained below.

As a few examples, banks might decide to stop offering overdraft protection, small loans, and credit cards to service members and dependents, to avoid including terms that would violate the new law.

For other categories of loans, a prohibited provision or two may be found in the bank’s standard loan documents, and may need to be deleted whenever the borrower is a service member or dependent.  (Failure to do so could make an entire loan void.)

Banks will probably also need to change their loan application process, to provide a clear means of identifying all service members and dependents that are covered by the new provisions.

1. Background

The law restricts “predatory lending,” but takes an overly broad approach.  Its provisions are drastic enough to reduce the availability of most types of credit to service members and their dependents.

The American Bankers Association would like the bill to be amended to completely exempt banks from its coverage. That change would be an ideal outcome (and would make everything in this article irrelevant for banks), but there’s no certainty that will happen.  Another helpful but less far-reaching solution would be to restrict the law’s coverage to those loan categories that are the main problem. 

In the meanwhile, until it becomes clear whether any changes are on the way, it’s useful to focus on compliance problems that this new law will create if something is not changed.

Apparently, “predatory” lenders are common around military facilities.  The U.S. Department of Defense (DOD) is concerned that service members and their families are falling prey to harsh lending practices, impacting both financial and emotional well-being.  Some service members with too much debt are even losing their security clearances, and are barred from serving abroad, because they represent a security risk.

In August the DOD issued a lengthy report detailing various predatory lending practices affecting the military.  The worst offenders are payday lenders, internet lenders, lenders who take a security interest in the equity in a borrower’s already-owned vehicle, rent-to-own programs, and tax-refund lenders.  The new law’s provisions will limit these practices in one way or another.

The U.S. Secretary of Defense is in charge of drafting regulations to implement the new law.  There are many overly-broad provisions that could be clarified or even narrowed by the regulations—if DOD is willing to do so. 

If the banking agencies were writing the regulations, they would certainly avoid imposing provisions that could limit credit availability.  DOD, however, is motivated differently.  If DOD’s regulations have the effect of restricting the amount and types of credit available to service members and their families, DOD would probably accept that result as justifiable, given the severity of the problems it wants to cure. 

When regulations implementing the new law are issued, we will get a clearer picture of the extent of the risks and pitfalls this new law poses for lenders.

2. What Transactions are Covered?

The law restricts the terms of “consumer credit” extended to service members and dependents (as explained in more detail below).  Significantly, DOD is not required to define “consumer credit” the same way the Federal Reserve defines it in Regulation Z.  The definition DOD chooses will determine what transactions the new law applies to.  The best result for banks would be to define “consumer credit” more narrowly than in Reg Z, so that the bill’s restrictions will only apply to “problem” categories of loans.  But this may be too much to hope for.

The new law’s definition of “consumer credit” (Section 987(i)(6) of 10 U.S.C.) states only that “consumer credit” as regulated by the law and as defined by DOD cannot include (1) a residential mortgage, nor (2) purchase-money financing of a car or other personal property, secured by the property being purchased.  Except for these two specific categories, DOD would be free to define “consumer credit” more broadly than Reg Z currently does—if it chooses to do that. 

Here’s one example of the “mischief” that could be done:  The Federal Reserve already considers “overdraft protection” to be credit; and the Fed can apply Regulation Z’s provisions to overdrafts, whenever it decides to do so.  But so far it has decided against that approach.  Maybe DOD would decide to include overdraft protection in consumer credit, if it believes overdraft charges are abusive to service members and it wants to correct the practice.  If DOD did that, the new law would cause all related fees (including overdraft fees) to be counted as interest—for service members and dependents.  Those fees then could not exceed 36% of the amount borrowed, on an annualized basis.  (If someone had an average overdrawn balance of $100, year-round, the total fees related to overdrafts couldn’t be more than about $36 annually, or an average of $3 per month.)  Banks would almost certainly terminate overdraft protection for service members and dependents, if this product were defined by DOD as consumer credit—or else banks would have to waive most of the fees in order to comply with the law.

3.  “Interest” Limited to 36%

Section 987(b) prohibits charging an annual rate of interest greater than 36% on consumer credit extended to a covered service member or dependent. This is the most widely-known provision of the new law.  If the law did only that much, it might seem reasonable.  (Most bankers wouldn’t try to argue that they need to charge more than 36%!)

And bankers might say, “We don’t make loans at a 36% rate of interest, so it won’t affect us!”  Unfortunately, the law’s provisions are nowhere near that simple.  Among other points, (1) the 36% is only a worst-case cap, not a permission; (2) DOD can set interest rates much lower than 36%–loan category by loan category; (3) any more restrictive provision in state law continues to apply; (4) any more permissive rate or fee provision in state law (more flexible than what DOD adopts) is pre-empted; (5) DOD can cap certain loan-related fees that it wants to limit, or can prohibit those fees altogether; and (6) even the 36% amount will not be “36% as we know it,” because it will include all fees charged in connection with a loan, including fees that Regulation Z clearly excludes from the finance charge.  When a bank must re-calculate its APR to include fees of all types, and it finds that certain fees are prohibited altogether, the new provisions may drastically change many lenders’ underwriting standards and pricing strategy for certain categories of loans to service members, including smaller loans, short-term loans, and credit cards.

Lenders in Oklahoma (including banks) do regularly make at least some loans at a legal APR greater than 36%–and these loans will require some changes.  Small loans originated in compliance with Section 3-508B of Oklahoma’s UCCC are not required to fit within a maximum annual percentage rate, but instead have a maximum “acquisition charge” plus a maximum monthly “installment account handling charge.”  When a bank calculates the actual APR on so-called “508B loans,” it will often come up with a rate exceeding 36%.  The new law will require a lender to reduce the charges on these loans—for service members and dependents.   

Although Oklahoma law allows a few “add-on” fees (late charges and deferral fees) for “508B loans,” the new law will require these fees, also, to fit within the 36% APR cap.  As a result, it will become almost impossible to charge late fees or deferral fees on “508B” loans made to service members and dependents.  

Banks are generally most interested in late fees as a way of ensure prompt payment.  Eliminating the late fees will make it easier for service members and dependents to slip into a pattern of paying less promptly.  In turn, a lender may need to spend more effort working loans that are late.  Lenders may ultimately tighten underwriting standards for loans made to service members and dependents, if the inability to charge a late fee gives the lender less control.   (Late fees on larger consumer loans are also required to be included in “interest,” but the added fees on larger loans are less likely to push the new law’s adjusted “APR” above the maximum.)

In terms of efficiency and profitability, most banks wouldn’t want to make a lot of small loans priced at “508B” rates.  It wouldn’t hurt banks to eliminate these loans altogether.  There are certain minimum expenses involved in taking an application, checking credit, preparing loan documents and disclosures, sending statements, and processing payments.  These costs do not decrease as the size of a loan gets substantially smaller.  A lender simply needs a higher return on a small loan, to cover these costs. 

And there are certain borrowers who need small loans—whether lenders want to offer such loans or not.  Borrowers in this segment often cannot afford high rates, but select high-rate lenders anyway, based on ease of borrowing, without considering that it’s a bad choice financially.  If too easy access to “bad choices” is eliminated (as this law attempts), perhaps at least some individuals with reasonably good credit will seek out banks more regularly, and will obtain better terms.  But those with bad credit will watch their current high-rate borrowing sources go away, and still will not qualify for lower-rate loans elsewhere.  

This new law will hit particularly hard at “payday lenders” near military facilities (as I will explain later).  Traditional finance companies (those making small “signature” loans at “508B” rates) will also be significantly affected, if a large number of their borrowers are military personnel.   

Depending on how the DOD regulation will define “consumer credit,” this law could also substantially affect pawnshop businesses located near military facilities. An Oklahoma pawnshop is limited by state law to an APR of 36% on loans of $1,000 or more. For pawnshop loans below $1,000, the maximum allowed annual interest rate increases as the size of the loan decreases.  On the smallest loans, an Oklahoma pawnshop can charge about a 240% APR. Of course, most pawns are for relatively small amounts, and decreasing the permitted APR to 36% on all such transactions could put out of business some of the pawnshops that currently rely heavily on military customers.

4. All Fees are “Interest”

Probably the most troublesome aspect of the new law is its definition of “interest,” in Section 987(i)(3):  “The term ‘interest’ includes all cost elements associated with the extension of credit, including fees, service charges, renewal charges, credit insurance premiums, any ancillary product sold with any extension of credit to a servicemember or servicemember’s dependent, as applicable, and any other charge or premium with respect to the extension of consumer credit.”

Banks are familiar with provisions in Regulation Z that specifically exclude certain fees from the finance charge—such as filing fees paid to public officials, late charges, overdraft charges, and the annual fee for maintaining a credit card.  Under the new law’s definition of “interest,” apparently no fees at all will be excluded from the finance charge, and so each of these fees just mentioned will be considered as part of “interest” on the transaction.  

As another example, Regulation Z specifically excludes credit insurance premiums from the finance charge if it is disclosed to the consumer that purchasing the insurance is voluntary.  The new law, by contrast, includes all credit insurance premiums in the finance charge.

Oklahoma’s UCCC also excludes from the finance charge (and allows to be charged in addition to the otherwise maximum APR) an over-the-limit fee or cash advance charge on a credit card, as well as a reasonable application fee, documentation fee, or fee for reviewing an applicant’s credit on any type of  consumer loan.  The new law apparently includes each of these fees in “interest.”

Banks might decide that service members are ineligible for certain loan products because the bank cannot impose various standard fees and charges that are part of a particular loan product’s design.

Assume, for example, that a bank’s standard consumer loan includes the $20.50 fixed-dollar late fee allowed by Oklahoma law.  This may be a fairly small loan with a reasonable APR; but the bank will still be required to include a late fee as part of “interest” charged.  On each date when a late fee is imposed, the bank presumably would have to re-calculate the total “interest” it has charged to date (actual interest plus all fees) to determine whether imposing another late fee would violate the 36% APR as calculated by DOD (or a lower maximum APR that DOD may establish for a particular type of loan).  Certainly, being required to recalculate “interest” each time a late fee is imposed is not convenient; but knowingly imposing excessive fees is a misdemeanor (discussed later). On this basis, a bank might decide to remove the late fee provision altogether on consumer loans for service members and dependents–and in turn might tighten its underwriting standards somewhat on loans where it cannot include this fee.

As another example, if a service member has a credit card with a $30 annual card fee and 12% APR, but the borrower carries no continuing balance on the card and makes only one $50 charge during the year, the annual fee alone (treated as interest) would result in an APR greater than 36%, and so would violate the new law.  If the annual fee exceeds the amount of total interest that can legally be charged, the card issuer must waive or reduce the fee.  Instead, the bank might decide that service members and dependents will only be eligible for a different credit card option, which involves a $0 annual fee but a 15% APR—instead of 12%.  (For a service member who uses his credit card a lot, this second option could be more expensive than a $30 annual fee and 12% APR—but it complies with law.)  

The bank also might deny service members and dependents the right to obtain cash advances on a credit card, because, depending on the circumstances, the bank cannot be sure in advance that it can charge its standard cash advance fees and still remain within the new law’s maximum permitted amount of “interest.”  

Going back a step, if a bank’s only available credit card program involves a $30 annual fee, a 12% APR, a 2 1/2% fee on cash advances, a $20 late fee and a $20 over-the-limit fee, the bank might find it easier not to issue credit cards to service members or their dependents, because the bank is unsure of being able to charge the various standard fees that make up part of this product’s pricing.

5. New Definition of “APR”

The law contains a new definition of “APR,” in Section 987(i)(4).  It first suggests that it is the same definition as under Regulation Z, but then it contradicts itself by stating that all fees (not just those included in the finance charge under Reg Z) are included in the “APR” for purposes of this law:

“The term ‘annual percentage rate’ has the same meaning as in section 107 of the Truth in Lending Act (15 U.S.C. 1606), as implemented by regulations of the Board of Governors of the Federal Reserve System.  For purposes of this section, such term includes all fees and charges, including charges and fees for single premium insurance and other ancillary products sold in connection with the credit transaction, and such fees and charges shall be included in the calculation of the annual percentage rate.”

In other words, for extensions of credit to service members and dependents, there now will be two different APR’s that must be calculated and disclosed.  Section 987(c)(1) requires a lender to determine both the APR as provided in Regulation Z and also the APR resulting from the definition above.  The lender then must disclose the two different APR calculations, both “orally and in writing,” before issuing credit to the service member or dependent.

Obviously, giving two sets of disclosures (instead of one) is a major complication for lenders.  The requirement to give disclosures “orally” is clearly designed to hamper internet lending programs that provide online loan applications and approvals—requiring no interaction with an actual person. In the future, lenders may have to exclude service members and dependents from online loan approval, or may need to call each applicant to give disclosures orally before a loan can be originated.  (But would an automated voice disclosure work?)

6. No Lender Access to Bank Account

For any consumer credit extended to a service member or dependent, Section 987(e)(5) makes it unlawful for the creditor to use “a check or other method of access to a deposit, savings, or other financial account maintained by the borrower, or the title of a vehicle as security for the obligation.”

This provision is designed to eliminate several practices that the DOD strongly dislikes–and it may impact more loan products than intended.

First, this provision strikes directly at lenders who make “payday loans” to service members and dependents.  Typically, payday lenders obtain a post-dated check from the borrower at the time of the loan.  The check is dated as of the borrower’s future payday.  As repayment of the loan, the lender deposits the post-dated check (on the day as of which it is dated), or sometimes presents the check directly to the borrower’s bank.

If the check is “insufficient,” the borrower has defaulted on the loan (on which he can be sued), and has also written a “hot check” (on which he may be prosecuted).   The borrower may owe the payday lender a “returned check” charge to redeem the bounced check, and/or will roll over the loan to a later payday, by agreeing to an additional finance charge.  So the cycle continues.

The new law will eliminate the practice of taking post-dated checks from service members and their dependents as a method of loan repayment, and by limiting the APR (including all fees) to 36%, will also fairly well destroy the economics of making payday loans to service members.

Second, the law will prohibit setting up a direct transfer from a bank account (or ACH debit) as a method of repaying any loan.  (However, this does not affect a residential mortgage loan, nor any purchase-money financing for a car or other personal property, because those transactions are specifically excluded from the statute’s coverage.)  

Regulation Z allows a borrower to set up automatic loan payments (direct transfers from a bank account at the same bank, or ACH debits at another bank).  A lender cannot require this method of payment of a loan, but the consumer can voluntarily establish this method of payment, and can discontinue it at any point.

The new law is more restrictive than Regulation Z, completely prohibiting a service member or dependent from authorizing automatic payments on “consumer credit”–even if the consumer would prefer the convenience of automatic electronic payments.

7. No Renewal of Debt

Section 987(e)(1) of the new law makes it unlawful to roll over, renew, repay, refinance or consolidate one consumer loan with the proceeds of another consumer loan from the same lender.  

This provision is intended to address abusive lending practices.  (The provision will not allow a lender to refinance or otherwise renew a debt owed to it by a service member or dependent—even if the terms are beneficial to the borrower.)

It is a regular practice of payday lenders to roll over one payday loan into a second one with a higher balance, and so on.  This process allows a borrower to “dig the hole deeper and deeper,” instead of reducing the debt.  Similarly, a person who obtains a loan from a pawnshop can sometimes extend the length of the pawn by paying an additional fee, without reducing what is owed.  Both of these practices are addressed by the new law; but the new restriction has the effect of eliminating even some consumer-friendly practices frequently engaged in by reputable lenders:

First, the law apparently makes it illegal to extend the payments on consumer debt on any basis.  This provision seems to prohibit a “work-out” with a troubled debtor—reducing the installment payment amount and extending the term.  A lender’s decision to bring a past-due consumer loan current to get the lender back on track (agreeing to skip one or more payments and extend the maturity) would also appear illegal with respect to service members and dependents. Even a lender’s typical “skip-a-payment at Christmas” plan for good-quality borrowers may be an impermissible renewal or refinancing of a consumer loan.

Second, the law seems to prevent a lender from making a “single payment” loan to a service member or dependent and then later renewing that loan (if the loan is not secured by real estate).  Generally, a lender would be willing to renew some of its single-payment notes (for example, because a borrower has an unexpected delay in receiving income), provided that the borrower pays the accrued interest and an appropriate principal reduction at renewal; but for service members and dependents, a lender cannot do this.

Third, a lender with more than one loan outstanding to a service member or dependent will not be able to consolidate that borrower’s loans into a single note.  Instead, a borrower wanting a consolidation loan will have to obtain it from another lender.  Although the existing lender might offer a consolidation loan on very fair terms, the borrower is forced to obtain a consolidation loan elsewhere.  This restriction reduces a borrower’s lending sources by one, and possibly eliminates a lender with whom the borrower already has a good working relationship.

This law’s anti-renewal provision is designed to protect service members from “predatory” lenders who replace existing notes with reworked or renewed notes—often holding out the carrot of “new money” to the borrower, while at the same time charging large fees for the renewal.  With repeated renewals, a borrower’s debt sometimes increases substantially over time, instead of decreasing.

Ideally, the DOD regulation would be written to narrow the new law’s scope, protecting those renewals and refinancings that are actually beneficial to the borrower.  But it’s too early to know what may happen.

8.  No Mandatory Arbitration

The new law, at Section 987(e)(3), makes it unlawful to require a borrower (a service member or dependent) to submit to arbitration any dispute arising from the extension of consumer credit.  This provision overrides state law.

As an example of a conflicting local provision, Oklahoma law generally allows a “mandatory arbitration” provision to be included in a consumer loan.  

(“Mandatory arbitration” does not mean that the borrower is forced to accept the result of arbitration—that would be “binding arbitration.”  Rather, mandatory arbitration requires a borrower to start with arbitration in attempting to resolve any dispute with a lender before filing a lawsuit.)

Arbitration can be valuable—although the new law assumes the opposite.  Arbitration forces the parties to meet for a face-to-face discussion of claims or grievances, supervised by an experienced arbitrator.  If this process can help people to better understand each other’s issues, the dispute can sometimes be settled without a lawsuit.

From a lender’s standpoint, another advantage of “mandatory arbitration” is that it tends to eliminate class-action lawsuits:  With arbitration, each borrower must first raise his claim against the lender in an individual arbitration proceeding, before participating in any lawsuit, including a class action.

The new law prohibits including an arbitration clause in a consumer loan that is made to service members and dependents.  The law is overly broad, overlooking the fact that an arbitration provision can be very “fair”—by providing that arbitration will be held only in the consumer’s local area, and that the lender will pay 100% of the costs for at least the first day of arbitration.

9. Non-complying Contracts Void

I have emphasized the law’s prohibition on arbitration, above, to demonstrate how even a relatively minor provision in the loan documents can cause big problems. Based on Section 987(f)(3), a consumer loan to a service member or dependent,  complying in every other respect with the new law, will apparently be “void from the inception” if any disallowed provision (such as arbitration, or authorization to automatically deduct a loan payment from a bank account) is included in the terms of the loan.

Although the DOD regulation could resolve this point more clearly, the new law’s provisions do suggest that a prohibited provision will cause the whole transaction to be void and unenforceable.  A lender perhaps will not be able to sue on a promissory note at all, if the documents contain a prohibited provision.

For each category of consumer loan regulated by the new law (whatever the DOD regulation covers), a lender may have to pick from among various compliance strategies that are not very satisfactory:

(1) First, the lender could design its software forms so that it has one set of loan documents complying with the special “service member or dependent” restrictions, and another set of documents for “regular” consumers.  But it’s messy for training and ongoing compliance, to have different versions of the same loan product, varying only because of the applicant’s military-related status (or not).  When there are “two sets of documents,” there’s always some risk that the lender will use the wrong set of forms—through error, or lack of awareness that the applicant meets the definition of “service member or dependent.” The new law’s restrictions apply automatically, even when the applicant himself is unaware—or fails to disclose—that he is classified as a “service member or dependent” under the new law.

(2) As a second possible approach, for certain categories of loans a lender could have just one set of loan documents, making every borrower’s loan terms exactly the same as required for service members and their dependents.  But this approach may give up too much.  (For non-military consumer borrowers, a lender probably does not want to eliminate “boilerplate” loan-document provisions that give the lender a security interest in deposit accounts, a contractual right to offset, and/or a cross-pledge of whatever collateral (such as a vehicle) may be pledged on other loans owed to the same lender.  A bank will not want to bar all borrowers from setting up a voluntary automatic deduction of loan payments from a bank account, just because service members and dependents are prohibited from authorizing automatic loan payments.) 

(3) A third possible approach would be for the bank to decide that it is going to price particular types of consumer loans however it sees fit—and will not offer those loans to service members or dependents if the new law in any way  prevents the lender from extending consumer credit on the terms that the lender has chosen.  As an example already given, if a lender’s credit card has a $30 annual fee, a 12% APR, a 2 1/2% cash advance fee calculated based on the amount advanced, a $20 late fee, and a $20 over-the-limit fee, the bank cannot know in advance how much money the individual might borrow during a year, and therefore cannot determine whether the total interest and fees established for this account, as charged during the year, will exceed a 36% APR calculated under the new law’s method.  Without being able to calculate the “new” APR in advance, and because it’s difficult to constantly re-calculate the APR as the year goes by to determine whether part of the ongoing fees need to be waived to comply with law, a lender may find it simpler to decline to offer its credit cards to service members and dependents.  In other words, this third possible approach to compliance is to modify nothing in the loan documents—but simply not to offer a loan if the applicant cannot legally agree to the terms that would be offered.

It’s probably not illegal to decline a loan based on a combination of (1) military status, and (2) restrictions in federal law that make it illegal to loan to service members and dependents on the same terms that the lender makes available to everyone else.  But it’s going to look bad if lenders start declining loans based on military status, rather than credit quality.  It may look unpatriotic, and may generate bad publicity.

(4) A fourth alternative (also not very good) is for a lender to eliminate all of the fees that may violate the new law, while keeping everything else the same.  (The problem is that the disallowed fees are part of the basis on which the lender priced the loan product—so without these fees, the lender is not fairly compensated.)

A threshold issue, even before choosing from among these various options, is to understand exactly what category of borrower the bank is dealing with. It may be necessary for lenders to add something to the standard consumer loan application, requiring every applicant to state whether he is or is not a service member or dependent of a service member, as defined in the new law.  The law may effectively force a bank to add “one more step” than existed previously–one more box to check or statement to initial—before originating any type of consumer loan (except for loans that DOD exempts from coverage).

10.  Criminal Provision

It wasn’t enough for the new law to state that a loan agreement with a prohibited provision is “void.”  It goes farther, establishing a misdemeanor offense:  “A creditor who knowingly violates this section shall be fined as provided in title 18 [USC], or imprisoned for not more than one year, or both.”

This criminal provision, like many other parts of the law, is overkill:  It makes no distinction between larger offenses and the smaller, more technical violations.  Literally, the criminal provision will apply to both (1) a lender making thousands of loans to service members at exorbitant rates and fees, and (2) a lender who does not remove an arbitration clause from one consumer loan, or who renews one consumer loan to a service member or dependent, or who sets up an automatic payment from a bank account to pay one service member’s loan.  I hope a federal District Attorney will not waste time attempting to prosecute someone for trivial violations of this new law—but the possibility remains. 

11. What Persons are Covered?

The restrictions and protections in the law automatically extend to “a covered member of the armed forces or a dependent of such a member.”  A lender must not charge certain fees, engage in certain practices, or include certain prohibited provisions in an extension of credit if a borrower fits in these categories.  From a compliance standpoint, the law is seriously flawed, because it does not require a borrower to disclose that he is a “covered member” or “dependent” before the protections kick in.  It’s theoretically possible for a bank to enter into a consumer loan transaction, then to discover months or years later that certain pricing terms and other provisions on which the transaction is made are illegal and unenforceable, and (possibly) that the whole transaction is void, because the borrower was a service member’s dependent.

The regulations might require a person to identify his status before the law’s restrictions will take effect–but if that clarification is not provided by DOD, a bank should be really careful, asking every customer verbally and in writing if he or she is a “covered member” or a “dependent”—and perhaps even explaining to each loan applicant what those definitions mean.

Generally, a bank will know when a loan applicant is a full-time service member, based on employment information.  Military status might not be so obvious when a loan applicant is in the National Guard or Reserves, and is only temporarily called up for active duty.

The definition in Section 987(i)(1) states that a “covered member” is “a member of the armed forces who is (A) on active duty under a call or order that does not specify a period of 30 days or less; or (B) on active Guard and Reserve Duty [no minimum time period required].”

A “dependent” of a service member will be more difficult for a lender to identify, if the person does not disclose that he/she qualifies as such.

Section 987(i)(2) defines “dependent,” with respect to a covered member, as “(A) the member’s spouse; (B) the member’s child (as defined in section 101(4) of title 38 [USC]); or (C) an individual for whom the member provided more than one-half of the individual’s support for 180 days immediately preceding an extension of consumer credit covered by this section.”  (This is not the same definition of dependent used in the IRS Code, for example.)

If a spouse applies for credit in her own name, and has separate income and credit history, a bank would not automatically be alerted that the applicant is a dependent of a service member and qualifies for the law’s protections.

The definition of “child” (cross-referenced to another federal definition) includes any child under 18; any child under 23 (whether self-supporting or not) who is attending college; and any child (regardless of current age) who became permanently incapable of self-support (disabled) before age 18.  It not only includes a child by blood, but also an adopted child, or a step-child (not legally adopted); and it specifically includes an illegitimate child.

“Child” could include someone with parents who are divorced and live in different states.  Perhaps a “child” has not seen or heard from the service-member parent in a dozen years, and receives no current support, but is a college student under 23.  When this “child” applies for “consumer credit”—even a simple credit card with a $500 limit–the law’s provisions will apply.  A lender cannot “assume” that its business will not involve service persons’ “dependents,” just because the lender is located far from any military installation.

Subpart (C) under the definition of “dependent” (above) can include anyone (related or not), if the service person provided more than half of that individual’s financial support during the previous 180 days.

This dependent test based on income can be a “moving target.” Consider a 23-year-old student in graduate school (too old for the definition of “child’) who works full-time in the summers but attends school full-time the rest of the year, while holding down a part-time job.  Measured at the end of August, this student might be providing more than half of her own support over the previous 180 days; but measured at the end of March, her father, a Reservist called up to temporary active duty, may have provided more than half of her support over the previous 180 days.

As another example, a normally self-supporting mother in her sixties develops a major medical condition for several months, which leaves her temporarily unable to work.  Her adult child (a Reservist called to temporary active duty) provides substantial financial assistance for a while.  Later, the mother returns to full-time work.  The calculation determining whether the mother is a “dependent” (whether she provided half of her support over the previous 180 days) can vary in its outcome from month to month.  It will matter when the specific loan application date is—whether it’s shortly after her disability, several months into her disability, or several months after she returns to full-time work.

What if, for example, a bank sends out mailed notices to persons who are “pre-approved” for a credit card, and the mother (who receives a notice) fills out the brief enclosed application form?  If she has just returned to work, she can truthfully disclose her current level of income, but technically she still may be a “dependent” based on the amount of financial assistance her Reservist child has provided during the previous 180 days, while she was ill.  If an abbreviated application is returned by mail, how would the bank that pre-approved her credit card actually know that she is a “dependent” of a service member (based on support), and that certain provisions and fees cannot be included in her consumer loan?

Correction: Early IRA Distributions to Reservists

The November 2006 Legal Update discussed various IRA provisions contained in the 2006 Pension Protection Act. That article correctly stated that a member of the National Guard or Reserves who is called to active duty can take an early IRA distribution without any 10% early-withdrawal penalty, under certain conditions. The article incorrectly stated that the early IRA distribution to a reservist called to active duty would be excluded from taxable income.

An early withdrawal by a reservist (through December 31, 2007) will be treated much the same as any other case in which an IRA early-withdrawal penalty is waived—for example, an early withdrawal by a first-time homebuyer to purchase a home, or an early withdrawal to pay qualifying higher-education expenses.  In each of these examples (including the reservist situation), the amount withdrawn early from the IRA is included in taxable income in the year of the withdrawal, but the 10% penalty is waived.

A reservist, however, may enjoy other favorable tax characteristics, with the result that there is little impact from including the IRA early withdrawal in income.  If most or all of a reservist’s income is non-taxable combat pay, counting the IRA early withdrawal as “taxable” still might not result in much actual tax owed.  By contrast, a reservist who has additional sources of taxable income (such as a spouse’s income on a joint return) could have more tax impact from including the IRA early distribution in taxable income.

A reservist called to active duty who takes an IRA early distribution because of financial need may have no other choice; but a reservist who has more than one option available should perhaps consult a tax adviser, to understand in advance the tax effect of taking an IRA early distribution that will be reported as  taxable income.